Exchange rate dynamics, asset market structure and the role of the ...

signi…es a log-deviation from steady state. The implication of this is that the real exchange
rate is perfectly correlated with and less volatile than the terms of trade. Both of these
characteristics are at odds with the data.
2.5 Market Equilibrium
The solution to our model satis…es the following market equilibrium conditions must hold
for the home and foreign country:
1. Home-produced intermediate goods market clears:
y t
= c Ht + c H t
+ x Ht + x H t
(23)
2. Foreign-produced intermediate goods market clears:
y t = c F t
+ c F t
+ x Ft + x F t
(24)
3. Bond Market clears:
B t + B t = 0 (25)
2.6 Solution technique
Before solving, I log-linearize the model around the nonstochastic steady state. In a neighborhood
of the nonstochastic steady state one can analyze the linearization of the model,
provided that the random shocks are su¢ ciently small. This procedure is standard in stochastic
rational expectations macroeconomic models and is valid (i.e. yields a close approximation)
provided the stochastic disturbances have a su¢ ciently small support. For a
justi…cation see Appendix A.3 of Woodford (2003). The linearization thus yields a set of
equations describing the equilibrium ‡uctuations of the model. The log-linearization yields
a system of linear di¤erence equations which can be expressed as a singular dynamic system
of the following form:
AE t y(t + 1 j t) = By(t) + Cx(t)
where y(t) is ordered so that the non-predetermined variables appear …rst and the predetermined
variables appear last, and x(t) is a martingale di¤erence sequence. There are four
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