This paper offers an explanation for the persistence observed in real exchange rate movements. The model combines pricing to market behavior with sticky prices generated by staggered contracts. A translog preference structure is used to enhance both features. The paper finds that openness limits the degree of endogenous persistence. Nevertheless, the model under reasonable parameter values can replicate the serial correlation of real exchange rate data. Further, significant exchange rate

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... ity can be generated, and this is amplified by the presence of endogenous persistence. and rcfeenstra@ucdavis.edu 4 The table closely resembles standard findings in the real business cycle literature: see Backus, Kehoe, and Kydland (1992) , Chari, Kehoe and McGrattan (1998a) , and Chang and Devereux (1998). 5 All data are logged and Hodrick-Prescott filtered quarterly series. The real exchange rate is computed as the CPI-adjusted bilateral exchange rate with the U.S. dollar. If we do not Hodrick-Prescott filter the real exchange rate data, the average serial correlation naturally is much higher: 0.94 for one quarter and 0.71 for four quarters. 6 See Froot and Rogoff (1995) for a summary of the time series literature. Several studies suggest real exchange rate deviations have a half-life of about four to five years. Some studies, such as Engel (1999), cast doubt on whether the real exchange rate is even mean reverting. 7 A related explanation for deviations from the law of one price, suggested in Devereux (1997), is that prices are sticky in the local currency of the buyer.