Working Paper: NBER ID: w31851
Authors: Zhengyang Jiang; Arvind Krishnamurthy; Hanno Lustig
Abstract: We characterize the relation between exchange rates and their macroeconomic fundamentals without committing to a specific model of preferences, endowment or menu of traded assets. When investors can trade home and foreign currency risk-free bonds, the exchange rate (conditionally) appreciates in states of the world that are worse for home investors than foreign investors. This prediction is at odds with the empirical evidence. We first show that it can be overturned (unconditionally) if the deviations from U.I.P. are large and exchange rates are highly predictable, which are conditions that do not hold in the data. More broadly, it is not possible to match the empirical exchange rate cyclicality (the Backus-Smith puzzle), the deviations from U.I.P. (the Fama puzzle) and the lack of predictability (the Meese-Rogoff puzzle). Second, our minimalist approach allows us to delineate the class of models that can resolve these puzzles. We show that introducing Euler equation wedges consistent with a home currency bias, home bond convenience yields/financial repression, or intermediary frictions can resolve all of these puzzles.
Keywords: No keywords provided
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| adverse macroeconomic shocks (F41) | exchange rate appreciation (F31) |
| home investor's marginal utility growth (D11) | exchange rate appreciation (F31) |
| exchange rate appreciation (F31) | domestic marginal utility growth > foreign marginal utility growth (F29) |
| macroeconomic conditions (E66) | unconditional exchange rate cyclicality (F31) |
| Euler equation wedges (D50) | deviations from UIP (F29) |
| financial shocks (F65) | Backus-Smith puzzle (C69) |