Exchange Rate Dynamics in a General Equilibrium Model with Decreasing Returns to Labor.

We develop an extension to the Obstfeld and Rogoff (1995, 1996) two sector model with imperfect competition and norminal wage rigidities. Contrary to the Obstfeld and Rogoff (1995, 1996) analysis, we assume that technology exhibits decreasing returns to scale. We analyze the implications for the exchange rate's reaction to an unexpected permanent rise in the money supply. The model replicates an overshooting result for certain parameter values, and we are able to isolate the effect of decreasing returns on the exchange rate. The exchange rate overshootes less compared to the situation in Obstfeld and Rogoff (1995, 1996), in which there is constant returns to scale.