Net foreign assets and the exchange rate: Redux revived

We revisit Obstfeld and Rogoff's (1995) results on exchange rate dynamics in a two-country, monetary model with incomplete asset markets, stationary net foreign assets, and endogenous monetary policy. The nominal exchange rate exhibits a unit root. Under flexible prices, it also depends on the stock of real net foreign assets. With sticky prices, the exchange rate depends on the past GDP differential, along with net foreign assets. Endogenous monetary policy and asset dynamics have consequences for exchange rate overshooting. A persistent relative productivity shock results in delayed overshooting under both flexible and sticky prices, A persistent relative interest rate shock generates undershooting under flexible prices. (C) 2002 Elsevier Science B.V. All rights reserved.