The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
This paper analyzes the dynamics of the real exchange rate and the price of equity for a small open economy using an optimizing model in which the process of capital accumulation entails adjustment costs. The analysis demonstrates that along an adjustment path toward long-run equilibrium, appreciation of the real exchange rate will accompany a decline in the market price of equity, whereas depreciation of the real exchange rate will accompany a rise in the price of equity. This relationship results from the requirement that non-traded inputs are used in the investment process. In the short-run, though, the effects on these variables depend critically on whether disturbances originate in the non-traded sector and on whether disturbances are perceived as temporary or permanent. The disturbances considered include changes in fiscal policies as well as changes in the world interest rate.