Real exchange rate puzzles
Encyclopedia
The real exchange-rate puzzles is a common term for two much-discussed anomalies of real exchange rates: that real exchange rates are more volatile
and show more persistence
than what most models can account for. These two anomalies are sometimes referred to as the purchasing power parity puzzles.
Dornbusch
's (1976) exchange rate overshooting
hypothesis argued that exchange rate volatility is essentially driven by monetary shocks interacting with sticky prices. This model can account for real exchange rate volatility, but does not say anything about the volatility of relative to output
or the persistence of the real exchange rate movements.
Chari
, Kehoe and McGrattan (2002) showed how a model with two countries and where prices were only allowed to change once-a-year had the potential to simultaneously account for the volatility of U.S. output and real exchange rates.
These two anomalies are related to, but should not be confused with, the Backus-Smith consumption-real exchange rate anomaly
, which is the observation that in most economic models the correlation between the real exchange rate and relative consumption is high and positive, whereas in the data it ranges from small and positive to negative.
Another real-exchange-rate anomaly was documented by Mussa (1986). In this paper Mussa documented that industrial countries which moved from fixed to floating exchange rate
regimes experienced dramatic rises in nominal-exchange-rate volatility. Since the volatility increases much more than what can be accounted for by changes in the domestic price levels, it means that the real-exchange-rate volatility increases. This is sometimes referred to as the «Mussa puzzle».
Obstfeld and Rogoff (2000) identified the purchasing power and exchange rate disconnect puzzle as one of the six major puzzles in international economics. These were the consumption correlation puzzle, home bias in trade puzzle
, the equity home bias puzzle
, the Feldstein-Horioka savings-investment correlations puzzle
, and the exchange rate regime puzzle. The sixth puzzle is described as "why exchange rates are so volatile and apparently disconnected from fundamentals". Here Obstfeld and Rogoff (2000) quotes the Meese and Rogoff (1983) exchange rate forecasting puzzle and the Baxter and Stockman (1989) neutrality of exchange rate regime puzzle. These two puzzles are closely to the Mussa puzzle as well as the other real exchange rate puzzles.
Volatility (finance)
In finance, volatility is a measure for variation of price of a financial instrument over time. Historic volatility is derived from time series of past market prices...
and show more persistence
Persistence
Persistence may refer to:* Image persistence, in LCD monitors* Multidrug tolerance, a dormant, persistent state of a bacterial population* Persistence , the characteristic of data that outlives the execution of the program that created it...
than what most models can account for. These two anomalies are sometimes referred to as the purchasing power parity puzzles.
Dornbusch
Rudi Dornbusch
Rüdiger "Rudi" Dornbusch was a German economist who worked for most of his career in the United States.-Biography:...
's (1976) exchange rate overshooting
Overshooting Model
The Overshooting Model or Exchange rate overshooting, first developed by economist Rudi Dornbusch, aims to explain why exchange rates have a high variance. A key element of the model is that expectations of exchange rate changes are "consistent" — that is, rational — rather than static...
hypothesis argued that exchange rate volatility is essentially driven by monetary shocks interacting with sticky prices. This model can account for real exchange rate volatility, but does not say anything about the volatility of relative to output
Output (economics)
Output in economics is the "quantity of goods or services produced in a given time period, by a firm, industry, or country," whether consumed or used for further production.The concept of national output is absolutely essential in the field of macroeconomics...
or the persistence of the real exchange rate movements.
Chari
V. V. Chari
Varadarajan Venkatachari Chari is an Indian-American economist and professor of economics at the University of Minnesota.-Biography:Chari received a Bachelor of Technology in Chemical Engineering from the Indian Institute of Technology, Bombay in 1974, and was a production engineer at Union Carbide...
, Kehoe and McGrattan (2002) showed how a model with two countries and where prices were only allowed to change once-a-year had the potential to simultaneously account for the volatility of U.S. output and real exchange rates.
These two anomalies are related to, but should not be confused with, the Backus-Smith consumption-real exchange rate anomaly
Backus-Smith puzzle
In economics, the Backus-Smith puzzle or consumption – real exchange rate anomaly is the observation that the correlations between consumption and real exchange rates are zero or negative. This is contrary to economic theory which predicts that with full risk sharing, relative consumption...
, which is the observation that in most economic models the correlation between the real exchange rate and relative consumption is high and positive, whereas in the data it ranges from small and positive to negative.
Another real-exchange-rate anomaly was documented by Mussa (1986). In this paper Mussa documented that industrial countries which moved from fixed to floating exchange rate
Floating exchange rate
A floating exchange rate or fluctuating exchange rate is a type of exchange rate regime wherein a currency's value is allowed to fluctuate according to the foreign exchange market. A currency that uses a floating exchange rate is known as a floating currency....
regimes experienced dramatic rises in nominal-exchange-rate volatility. Since the volatility increases much more than what can be accounted for by changes in the domestic price levels, it means that the real-exchange-rate volatility increases. This is sometimes referred to as the «Mussa puzzle».
Obstfeld and Rogoff (2000) identified the purchasing power and exchange rate disconnect puzzle as one of the six major puzzles in international economics. These were the consumption correlation puzzle, home bias in trade puzzle
Home bias in trade puzzle
The Home bias in trade puzzle is a widely-discussed problem in macroeconomics and international finance, first documented by John T. McCallum in an article from 1995....
, the equity home bias puzzle
Equity home bias puzzle
The Equity home bias puzzle is the term given to describe the fact that individuals and institutions in most countries hold only modest amounts of foreign equity. This is puzzling since observed returns on national equity portfolios suggest substantial benefits from international diversification...
, the Feldstein-Horioka savings-investment correlations puzzle
Feldstein-Horioka puzzle
The Feldstein-Horioka puzzle is a widely-discussed problem in macroeconomics and international finance, first documented by Martin Feldstein and Charles Horioka in an 1980 paper. According to economic theory, if we assume that investors that are able to easily invest anywhere in the world, they ...
, and the exchange rate regime puzzle. The sixth puzzle is described as "why exchange rates are so volatile and apparently disconnected from fundamentals". Here Obstfeld and Rogoff (2000) quotes the Meese and Rogoff (1983) exchange rate forecasting puzzle and the Baxter and Stockman (1989) neutrality of exchange rate regime puzzle. These two puzzles are closely to the Mussa puzzle as well as the other real exchange rate puzzles.