A Possible Explanation Of The Exchange Rate Disconnect Puzzle

Meese and Rogoff (1983) and subsequent studies find that economic fundamentals are apparently not able to explain exchange rate movements, but we argue that this so-called “Exchange Rate Disconnect Puzzle” arose because researchers such as Meese and Rogoff (1983) did not use the right fundamentals and because they did not allow for the forward-looking nature of exchange rate determination. Further, because they apparently were not aware that financial markets by themselves could not equalise interest rates across countries, they did not properly appreciate that the exchange rate is strongly influenced by agents' expectations of aggregated differences in local returns. Thus, we believe that the same underlying explanation provided by Ford (2015) and Ford and Horioka (2016a and 2016b) for the Feldstein-Horioka (1980) Puzzle and the PPP Puzzle - namely that financial markets alone cannot achieve net transfers of financial capital and cannot equalise real interest rates across countries - also helps explain why previous attempts to connect changes in the exchange rate to economic fundamentals have not been successful, and so can also be said to contribute to solving the Exchange Rate Disconnect Puzzle.

We propose a dynamic general equilibrium model of exchange rate determination, which simultaneously accounts for all major puzzles associated with nominal and real exchange rates. This includes the Meese-Rogoff disconnect puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus- Smith puzzle, and the UIP puzzle. The model has two main building blocks - the driving force (or the exogenous shock process) and the transmission mechanism - both crucial for the quantitative success of the model. The transmission mechanism - which relies on strategic complementarities in price setting, weak substitutability between domestic and foreign goods, and home bias in consumption - is tightly disciplined by the micro-level empirical estimates in the recent international macroeconomics literature. The driving force is an exogenous small but persistent shock to international asset demand, which we prove is the only type of shock that can generate the exchange rate disconnect properties. We then show that a model with this financial shock alone is quantitatively consistent with the moments describing the dynamic comovement between exchange rates and macro variables. Nominal rigidities improve on the margin the quantitative performance of the model, but are not necessary for exchange rate disconnect, as the driving force does not rely on the monetary shocks. We extend the analysis to multiple shocks and an explicit model of the financial sector to address the additional Mussa puzzle and Engel's risk premium puzzle.

This paper offers a dynamic noisy rational expectations model of the foreign exchange market with two dimensions of information asymmetry. Some investors are assumed to have public information, the rest are assumed to possess both public and private information. This paper demonstrates why solutions to the widely documented exchange rate disconnect puzzle should take into account these dimensions of information asymmetry in the markets. It is shown in the model that as proportion of investors possessing only public information to those possessing both types of information changes, the disconnect between macroeconomic variables and the exchange rate reacts to changes in this proportion in important ways. A surprising finding is that this disconnect is bigger when the proportion of investors possessing more information about fundamentals in the market is smaller.

We propose a dynamic general equilibrium model of exchange rate determination, which simultaneously accounts for all major puzzles associated with nominal and real exchange rates. This includes the Meese-Rogoff disconnect puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus- Smith puzzle, and the UIP puzzle. The model has two main building blocks -- the driving force (or the exogenous shock process) and the transmission mechanism -- both crucial for the quantitative success of the model. The transmission mechanism -- which relies on strategic complementarities in price setting, weak substitutability between domestic and foreign goods, and home bias in consumption -- is tightly disciplined by the micro-level empirical estimates in the recent international macroeconomics literature. The driving force is an exogenous small but persistent shock to international asset demand, which we prove is the only type of shock that can generate the exchange rate disconnect properties. We then show that a model with this financial shock alone is quantitatively consistent with the moments describing the dynamic comovement between exchange rates and macro variables. Nominal rigidities improve on the margin the quantitative performance of the model, but are not necessary for exchange rate disconnect, as the driving force does not rely on the monetary shocks. We extend the analysis to multiple shocks and an explicit model of the financial sector to address the additional Mussa puzzle and Engel's risk premium puzzle.

We present a simple framework in which both the exchange rate disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with 'deep' habits. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese-Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.

''In summary, the book is valuable as a textbook both at the advanced undergraduate level and at the graduate level. It is also very useful for the economist who wants to be brought up-to-date on theoretical and empirical research on exchange rate behaviour.'' ""Journal of International Economics""