Exchange Rate Disconnect Puzzle Research Articles

The Effect of Exchange Rates on Chinese Trade: A Dual Margin Approach

ABSTRACT Previous studies investigating the effect of exchange rate changes on a country’s exports have found little evidence that exchange rates matter. This “Exchange Rate Disconnect Puzzle” may stem from the fact that studies have mostly focused on aggregate data. Using HS-6 digit product-level data for Chinese exports, we analyze the effect of real exchange rate (RER) as well as the volatility of RER of the Chinese RMB. By decomposing China’s exports into its “extensive” and “intensive margins,” we find that RER volatility significantly impacts Chinese exports via both the margins. RER volatility increases the uncertainty and deters new firms from entering the market. As less firms operate, the export share of the existing firms increase. The overall effect of this volatility is slightly positive. We find that these effects are dominant for the minor trading partners of China compared to its major trading partners. We find weak evidence that RER depreciation affects China’s exports via the extensive margin.

Exchange Rate Disconnect Puzzle: A Review of Literature

<p><span lang="EN-GB">The exchange rate disconnect puzzle has been haunting economists for over four decades now. That the volatility in the movement of both real and nominal exchange rates has no linkage with macroeconomic fundamentals is a mystery. This paper selectively reviews the literature on attempts to resolve this puzzle.</span></p>

FX Trading and the Exchange Rate Disconnect Puzzle

This paper examines how trading in the FX market carries the information that drives movements in currency prices over minutes, days and weeks; and now those movements are connected to interest rates. The paper first presents a model of FX trading in a Limit Order Book (LOB) that identifies how information from outside the market is reflected in FX prices and trading patterns. I then empirically examine this transmission process with the aid of a structural VAR estimated on 13 years of LOB trading data for the EURUSD, the world's most heavily traded currency pair. The VAR estimates reveal several new findings: first, they show that shocks from outside the LOB affect FX prices through both liquidity and information channel; and that the importance of these channels varies according to the source of the shock. Liquidity effects on FX prices are temporary, lasting between two and ten minutes, while information effects of shocks on prices are permanent. Second, the contemporaneous correlation between price changes and order flows varies across the shocks. Some shocks produce a positive correlation (as in standard trading models), while others produce a negative correlation. Third, the model estimates imply that intraday variations in FX prices are overwhelmingly driven by one type of shock, it accounts for 87% of hour-by-hour changes in the FX prices. The second part of the paper examines the connection between the shocks in the trading model and the macroeconomy. For this purpose, I use the VAR estimates to decompose intraday FX price changes and order flows into separate components driven by different shocks. I then aggregate these components into daily and weekly series. I find that one component of daily order flow is strongly correlated with changes in the long-term interest differentials between US and EUR rates. This suggests that the intraday shocks driving this order flow component carry news about future short-term interest rates which is embedded into FX prices. I find that intraday shocks carrying interest-rate information account for on average 56% of the variance in daily EURUSD depreciation rate between 2003 and 2015, but their variance contributions before 2007 and after 2011 are over 80%. These findings indicate that the EURUSD depreciation rate is relatively well-connected to macro fundamentals via a particular component of order flow. Finally, I show that flows embedding liquidity risk have forecasting power for daily and weekly EURUSD depreciation rates.

A possible explanation of the ‘Exchange Rate Disconnect Puzzle’: a common solution to three macroeconomic puzzles?

ABSTRACTMeese and Rogoff (1983) and subsequent studies find that economic fundamentals are apparently not able to explain exchange rate movements, but we argue that this so-called ‘Exchange Rate Disconnect Puzzle’ arose because researchers such as Meese and Rogoff (1983) did not use the right fundamentals and because they did not allow for the forward-looking nature of exchange rate determination. Further, because they apparently were not aware that financial markets by themselves could not equalize interest rates across countries, they did not properly appreciate that the exchange rate is strongly influenced by agents’ expectations of aggregated differences in local returns. Thus, we believe that the same underlying explanation provided by Ford (2015) and Ford and Horioka (2016a, 2016b) for the Feldstein-Horioka (1980) Puzzle and the PPP Puzzle – namely that financial markets alone cannot achieve net transfers of financial capital and cannot equalize real interest rates across countries – also helps explain why previous attempts to connect changes in the exchange rate to economic fundamentals have not been successful and so can also be said to contribute to solving the Exchange Rate Disconnect Puzzle.

A Possible Explanation of the Exchange Rate Disconnect Puzzlee: A Common Solution to Three Major Macroeconomic Puzzles?

Meese and Rogoff (1983) and subsequent studies find that economic fundamentals are apparently not able to explain exchange rate movements, but we argue that this so-called “Exchange Rate Disconnect Puzzle” arose because researchers such as Meese and Rogoff (1983) did not use the right fundamentals and because they did not allow for the forward-looking nature of exchange rate determination. Further, because they apparently were not aware that financial markets by themselves could not equalise interest rates across countries, they did not properly appreciate that the exchange rate is strongly influenced by agents’ expectations of aggregated differences in local returns. Thus, we believe that the same underlying explanation provided by Ford (2015) and Ford and Horioka (2016a and 2016b) for the Feldstein-Horioka (1980) Puzzle and the PPP Puzzle - namely that financial markets alone cannot achieve net transfers of financial capital and cannot equalise real interest rates across countries - also helps explain why previous attempts to connect changes in the exchange rate to economic fundamentals have not been successful, and so can also be said to contribute to solving the Exchange Rate Disconnect Puzzle.

Debt denomination, exchange-rate variations and the margins of trade

Using firm-level data, we find that a currency depreciation has two opposite effects on exports when firms are indebted in foreign currency: (i) a pro-competitive effect that increases both the amount of exports by firm (the intensive margin) and the number of firms (the extensive margin); and (ii) a balance-sheet effect that forces some firms to exit the export market and decreases the extensive margin. These results both provide an explanation for the negative reactions of trade after recent emerging market crises and document a finance-based empirical microfoundation to the ‘exchange-rate disconnect puzzle’.

Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle

Rational expectations models fail to explain the disconnect between the exchange rate and macroeconomic fundamentals. In line with survey evidence on the behaviour of foreign exchange traders, we introduce model misspecification and learning into a standard monetary model. Agents use simple forecasting rules based on a restricted information set. They learn about the parameters and performance of different models and can switch between forecasting rules. We compute the implied post-Bretton Woods US dollar-pound sterling exchange rate and show that the excess volatility of the exchange rate return can be reproduced with low values of the learning gain. Both assumptions, misspecification and learning, are necessary to generate this result. However, the implied correlations with the fundamentals are higher than in the data. Including more lags in the model tends to tip the balance of our findings slightly towards rational expectations and away from the learning hypothesis.

Order flows and the exchange rate disconnect puzzle

The aim of this paper is to establish the link between the high frequency dynamics of spot exchange rates and developments in the macroeconomy. To do so, I first present a theoretical model of exchange-rate determination that bridges the gap between existing microstructure and traditional models. The model examines how dispersed microeconomic information known to individual agents outside the foreign exchange market is aggregated and transmitted to dealers via transaction flows (i.e., order flow); and how the information is then embedded in the spot exchange rate. I then report empirical evidence that strongly supports the presence of the link between the macroeconomy, order flow, and high frequency exchange rate returns implied by the model. In fact, my empirical results indicate that between 20 and 30% of the variance in excess currency returns over one- and two-month horizons can be linked back to developments in the macroeconomy. This level of explanatory power is an order of magnitude higher than that found in traditional models — even the newly developed monetary models incorporating central banks reaction functions. Moreover, it provides a straightforward solution to the exchange-rate disconnect puzzle. Namely, the high frequency behavior of spot exchange rates reflects the flow of new information reaching dealers concerning the slowly evolving state of the macroeconomy, rather than the effects of shocks that drive rapidly changing macroeconomic conditions.

Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle

Rational expectations models fail to explain the disconnect between the exchange rate and macroeconomic fundamentals. In line with survey evidence on the behaviour of foreign exchange traders, we introduce model misspecification and learning into a standard monetary model. Agents use simple forecasting rules based on a restricted information set. They learn about the parameters and performance of different models and can switch between forecasting rules. We compute the implied US-UK post-Bretton Woods exchange rate and show that the excess volatility of the exchange rate return can be reproduced with low values of the learning gain. Both assumptions, misspecification and learning, are necessary to generate this result. However, the implied correlations with the fundamentals are higher than in the data. Including more lags in the model tilts the balance of our findings slightly towards rational expectations and away from the learning hypothesis.

The Exchange Rate Disconnect Puzzle: A Resolution?

Early empirical studies of exchange rate determinants demonstrated that fundamentals-based monetary models were unable to outperform the benchmark random walk model in out-of-sample forecasts while later papers found evidence in favor of long-run exchange rate predictability. More recent theoretical works have adopted a microeconomic structure; a utility-based new open economy macroeconomic framework and a rational expectations present value model. Some recent empirical work argues that if the models are adjusted for parameter instability, it is a good predictor of nominal exchange rates while others use aggregate idiosyncratic volatility to generate good predictions. This latest research supports the idea that fundamental economic variables are likely to influence exchange rates especially in the long run and further that the emphasis should change to the economicvalue or utility based value to assess these macroeconomic models.

A Re-Examination of the Exchange Rate Disconnect Puzzle: Evidence from Japanese Firm Level Data

The empirical literature examining aggregate data has generally found small or insignificant effects of rate fluctuations on export volumes. This lack of association between real quantities, such as export volumes and the rate is the so-called exchange rate disconnect puzzle. Using firm level data, however, the relationship between export volumes and rates turns to significantly negative. This paper attempts to reconcile these aggregate and firm level findings, using firm level data from Japan. We estimate a simple microeconomic model of exports to show that an appreciation of the rate reduces export volumes at the firm level. After consistent aggregation, the relationship still remains significant at aggregate levels. However, we show that the omission of some key productivity variables, or ignoring the distributions of heterogeneous firm level characteristics biases the elasticity of exports to rates toward zero.

The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?

The central claim in this paper is that by explicitly introducing costs of international trade (narrowly, transport costs, but more broadly, tariffs, nontariff barriers, and other trade costs), one can go far toward explaining a great number of the main empirical puzzles that international macroeconomists have struggled with over twenty-five years. Our approach elucidates J. McCallum's home-bias-in-trade puzzle, the Feldstein-Horioka saving-investment puzzle, the French-Poterba equity-home-bias puzzle, and the Backus-Kehoe-Kydland consumption-correlations puzzle. That one simple alteration to an otherwise canonical international macroeconomic model can help substantially to explain such a broad range of empirical puzzles, including some that previously seemed intractable, suggests a rich area for future research. We also address a variety of international pricing puzzles, including the purchasing-power-parity puzzle emphasized by Rogoff, and what we term the exchange-rate disconnect puzzle. The latter category of riddles includes the Meese-Rogoff exchange-rate forecasting puzzle and the Baxter-Stockman neutrality-of-exchange-rate-regime puzzle. Here, although many elements need to be added to our extremely simple model, trade costs still play an essential role.

The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?

The central claim in this paper is that by explicitly introducing costs of international trade (narrowly, transport costs, but more broadly, tariffs, nontariff barriers, and other trade costs), one can go far toward explaining a great number of the main empirical puzzles that international macroeconomists have struggled with over twenty-five years. Our approach elucidates J. McCallum's home-bias-in-trade puzzle, the Feldstein-Horioka saving-investment puzzle, the French-Poterba equity-home-bias puzzle, and the Backus-Kehoe-Kydland consumption-correlations puzzle. That one simple alteration to an otherwise canonical international macroeconomic model can help substantially to explain such a broad range of empirical puzzles, including some that previously seemed intractable, suggests a rich area for future research. We also address a variety of international pricing puzzles, including the purchasing-power-parity puzzle emphasized by Rogoff, and what we term the exchange-rate disconnect puzzle. The latter category of riddles includes the Meese-Rogoff exchange-rate forecasting puzzle and the Baxter-Stockman neutrality-of-exchange-rate-regime puzzle. Here, although many elements need to be added to our extremely simple model, trade costs still play an essential role.