Exchange Rate Disconnect and the Trade Balance

Abstract

We propose a model with costly international financial intermediation that links exchange rate movements to shifts in the demand for domestically produced goods relative to the demand for imported goods (trade rebalancing). Our model is consistent with stylized facts of exchange rate dynamics, including those related to the trade balance, which is typically overlooked in the literature on exchange rate determination. In a quantitative assessment, trade rebalancing explains nearly 50 percent of exchange rate fluctuations over the business cycle, whereas exogenous deviations from the uncovered interest rate parity—the primary source of exchange rate fluctuations in the literature—account for just above 20 percent. Using data on trade flows or the trade balance is key to properly identifying the determinants of the exchange rate. Thus, our model overcomes the sharp dichotomy between the real exchange rate and the macroeconomy embedded in other models of exchange rate determination.