The Exchange Rate and the Current Account when Prices Evolve Sluggishly: a Simplification of the Dynamics and a Reconciliation with the Absorption Approach

Abstract

On the occasions when we focused attention on the relation between the exchange rate and the current account we took output to be always at its full employment level by assuming prices to be perfectly flexible. On the occasions when prices were taken to be sticky in the short run and attention was focused on the relation between output and the exchange rate the current account was neglected completely. The time has come to enrich our analysis by looking into the relation between the current account, the exchange rate and other variables within a model where prices are sticky in the short run and expectations are rational. One of our main motives in this chapter is to develop a rather comprehensive and not too complicated framework of dynamic analy sis that allows us to extract further results without much sacrifice in intuition or analytic tractability.