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

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  • Horioka, Charles Yuji
  • Ford, Nicholas

Abstract

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.

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  • Horioka, Charles Yuji & Ford, Nicholas, 2016. "A Possible Explanation of the 'Exchange Rate Disconnect Puzzle': A Common Solution to Three Major Macroeconomic Puzzles?," AGI Working Paper Series 2016-15, Asian Growth Research Institute.
    • Handle: RePEc:agi:wpaper:00000112
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    References listed on IDEAS

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    1. Nicholas Ford & Charles Yuji Horioka, 2017. "The ‘real’ explanation of the Feldstein–Horioka puzzle," Applied Economics Letters, Taylor & Francis Journals, vol. 24(2), pages 95-97, January.
    2. Flood, Robert P. & Rose, Andrew K., 1995. "Fixing exchange rates A virtual quest for fundamentals," Journal of Monetary Economics, Elsevier, vol. 36(1), pages 3-37, August.
    3. Alan M. Taylor & Mark P. Taylor, 2004. "The Purchasing Power Parity Debate," Journal of Economic Perspectives, American Economic Association, vol. 18(4), pages 135-158, Fall.
    4. Flood, Robert P & Rose, Andrew K, 1999. "Understanding Exchange Rate Volatility without the Contrivance of Macroeconomics," Economic Journal, Royal Economic Society, vol. 109(459), pages 660-672, November.
    5. Feldstein, Martin & Horioka, Charles, 1980. "Domestic Saving and International Capital Flows," Economic Journal, Royal Economic Society, vol. 90(358), pages 314-329, June.
    6. Alan M. Taylor & Mark P. Taylor, 2004. "The Purchasing Power Parity Debate," Journal of Economic Perspectives, American Economic Association, vol. 18(4), pages 135-158, Fall.
    7. MacDonald, Ronald, 1999. "Exchange Rate Behaviour: Are Fundamentals Important?," Economic Journal, Royal Economic Society, vol. 109(459), pages 673-691, November.
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    Cited by:

    1. Comunale, Mariarosaria & Kunovac, Davor, 2017. "Exchange rate pass-through in the euro area," Working Paper Series 2003, European Central Bank.
    2. Horioka, Charles Yuji & Ford, Nicholas, 2017. "The Solution to the Feldstein-Horioka Puzzle," AGI Working Paper Series 2017-17, Asian Growth Research Institute.

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    More about this item

    Keywords

    Exchange Rate Disconnect Puzzle; exchange rate determination; exchange rate volatility; Feldstein‐Horioka puzzle or paradox; financial market integration; goods market integration; international capital flows; international capital mobility; net transfers of capital; PPP puzzle; purchasing power parity puzzle; real interest rate equalisation; real interest rate parity; Exchange Rate Disconnect Puzzle; exchange rate determination; exchange rate volatility; Feldstein‐Horioka puzzle or paradox; financial market integration; goods market integration; international capital flows; international capital mobility; net transfers of capital; PPP puzzle; purchasing power parity puzzle; real interest rate equalisation; real interest rate parity; F21; F31; F32; F36; G15;
    All these keywords.

    JEL classification:

    • F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F32 - International Economics - - International Finance - - - Current Account Adjustment; Short-term Capital Movements
    • F36 - International Economics - - International Finance - - - Financial Aspects of Economic Integration
    • G15 - Financial Economics - - General Financial Markets - - - International Financial Markets

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