Alan Stockman for helpful discussions, as well as seminar participants at the Banca d’Italia, Boston College, the 1999 SED Meeting, and Wharton. All remaining errors are our own. The views expressed here are those of the authors and do not necessarily represent those of the Banca d’Italia, the Federal Reserve Bank of Philadelphia, or the Federal Reserve System.

This paper develops a two-country, two-sector general equilibrium business cycle model with nominal rigidities featuring deviations from the law of one price. A model with such building blocks can quantitatively account for the well-established fact that, of the statistical properties of most macroeconomic variables, only the volatility of the real and nominal exchange rates has dramatically changed after the fall of the Bretton Woods system. Moreover, we show that simulated data from our artificial economy can reproduce the findings of some explicit tests proposed in the literature, relating the volatility of fundamentals and exchange rates across regimes.