Working Paper: NBER ID: w23401
Authors: Oleg Itskhoki; Dmitry Mukhin
Abstract: 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.
Keywords: Exchange Rate; General Equilibrium; Asset Demand
JEL Codes: E30; F30; F4
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| international asset demand shock (G15) | exchange rate disconnect properties (F31) |
| international asset demand shock (G15) | volatility of exchange rates (F31) |
| small, persistent shocks to international asset demand (F32) | volatility of nominal and real exchange rates (F31) |
| international asset demand shock (G15) | comovement between exchange rates and macro variables (F31) |
| financial shock (G01) | negative correlation between relative consumption and real exchange rate depreciation (F31) |
| financial shock (G01) | forward premium puzzle (F31) |