Imperfect asset substitutability and exchange rate dynamics

Two broad classes of models of exchange rate dynamics can be distinguished in the literature. Sticky price models in which exchange rate dynamics is the result of slowly adjusting prices; and flexible price models in which exchange rate dynamics is the result of wealth accumulation through current account imbalances. The present paper analyses exchange rate dynamics in a model that integrates slowly adjusting prices with wealth accumulation dynamics. Henderson[3](1980) and Kawai[4] (1985) have attempted a similar synthesis under perfect asset substitutability. In this paper we extend the analysis to imperfect asset substitutability and enlarge the choice of assets to domestic and foreign currency and domestic- and foreign-currency denominated bonds. A serious deficiency, shared by both sticky price models and wealth accumulation models, is the assumption that trade flows adjust instantaneously to relative prices, while in reality, this reaction is distributed over time. This assumption has important implications for exchange rate dynamics and the overshooting hypothesis in particular (see, e.g. Niehans[5] 1977). In this paper we extend the analysis to consider the dynamic adjustment path of the exchange rate when trade flows react sluggishly to relative prices. Finally, the analysis is further extended by enriching the wealth accumulation process through its interaction with the government budget constraint.