Exchange Rate Disconnect in General Equilibrium

Abstract

We propose a dynamic general equilibrium model of exchange rate determination, which simultaneously accounts for all major exchange rate puzzles. This includes the Meese-Rogoff disconnect puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus-Smith puzzle, and the UIP puzzle. We build on a standard international real business cycle model augmented with a financial sector with noise traders and risk-averse intermediaries, which results in equilibrium UIP deviations due to limits to arbitrage. We show that financial UIP shocks result in persistent near-martingale processes for exchange rates and ensure empirically relevant comovement properties between exchange rates and macro variables, including excess exchange-rate volatility relative to aggregate consumption and output. In contrast, conventional productivity and monetary shocks, while successful in explaining the international business cycle comovement, result in counterfactual exchange rate dynamics with insufficient volatility. As a result, when combined together, the two sets of shocks reproduce both the exchange rate disconnect behavior and the empirical business cycle properties. The transmission mechanism relies on a conventional Taylor rule, home bias in consumption, and muted pass-through of exchange rates into prices and quantities due to pricing to market and weak substitutability between home and foreign goods. Nominal rigidities improve somewhat the quantitative performance of the model, yet are not necessary for the exchange rate disconnect, as monetary shocks are not the key drivers of the exchange rate.