Working Paper: CEPR ID: DP9842
Authors: Xavier Gabaix; Matteo Maggiori
Abstract: We provide a theory of the determination of exchange rates based on capital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus impacting both the level and volatility of exchange rates. Our theory of exchange rate determination in imperfect financial markets not only rationalizes the empirical disconnect between exchange rates and traditional macroeconomic fundamentals, but also has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and seldom perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. We derive conditions under which heterodox government financial policies, such as currency interventions and taxation of capital flows, can be welfare improving. Our framework is flexible; it accommodates a number of important modeling features within an imperfect financial market model, such as non-tradables, production, money, sticky prices or wages, various forms of international pricing-to-market, and unemployment.
Keywords: capital flows; exchange rate disconnect; foreign exchange intervention; limits of arbitrage
JEL Codes: E42; E44; F31; F32; F41; F42; G11; G15; G20
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| capital flows (F32) | balance sheets of financiers (G32) |
| balance sheets of financiers (G32) | required compensation for currency risk (F31) |
| required compensation for currency risk (F31) | exchange rates (F31) |
| capital flows (F32) | exchange rates (F31) |