Working Paper: CEPR ID: DP13839
Authors: Philippe Bacchetta; Eric van Wincoop
Abstract: The objective of this paper is to show that the proposal by Froot and Thaler (1990)of delayed portfolio adjustment can account for a broad set of puzzles about therelationship between interest rates and exchange rates. The puzzles include: i) thedelayed overshooting puzzle; ii) the forward discount puzzle (or Fama puzzle); iii)the predictability reversal puzzle; iv) the Engel puzzle (high interest rate currenciesare stronger than implied by UIP); v) the forward guidance exchange rate puzzle;vi) the absence of a forward discount puzzle with long-term bonds. These resultsare derived analytically in a simple two-country model with portfolio adjustmentcosts. Quantitatively, this approach can match all targeted moments related tothese puzzles.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Monetary contraction raises interest rate (E43) | Initial appreciation of the currency (F31) |
| Initial appreciation of the currency (F31) | Gradual depreciation (D25) |
| High interest rate currencies have positive excess returns (F31) | Forward discount puzzle (C78) |
| Gradual portfolio adjustments enhance predictability of exchange rate movements (F31) | Strengthened forward discount puzzle (E43) |
| High interest rate currencies initially have positive expected excess returns (F31) | Predictability reversal puzzle (D81) |
| Expected excess returns can turn negative over time (G17) | Predictability reversal puzzle (D81) |
| High interest rate currencies being stronger than implied by UIP (F31) | Engel puzzle (Y60) |
| Current exchange rate is more responsive to expected interest rates in the near future (E43) | Forward guidance exchange rate puzzle (F31) |
| Current exchange rate is less responsive to expected interest rates in the distant future (E43) | Forward guidance exchange rate puzzle (F31) |