Federal Reserve Bank of New York
New York University and NBER
Lars E.O. Svensson
CEPR, and NBER
This version: September 2007
We explore the implications of current-account adjustment for monetary policy within a simple two-country DSGE model. Our framework nests Obstfeld and Rogoff’s (2005) static model of exchange-rate responsiveness to current-account reversals. It extends this approach by endogenizing the dynamic adjustment path and by incorporating production and nominal price rigidities in order to study the role of monetary policy. We consider two different adjustment scenarios. The first is a “slow burn” where the adjustment of the current-account deficit of the home country is smooth and slow. The second is a “fast burn” where, owing to a sudden shift in expectations of relative growth rates, there is a rapid reversal of the home country’s current account. We examine several different monetary policy regimes under each of these scenarios. Our principal finding is that the behavior of the domestic variables (for instance, output and inflation) is quite sensitive to the monetary policy regime, while the behavior of the international variables (for instance, the current account and the real exchange rate) is less so.