Exchange-Rate Dark Matter

Dark matter is believed to account for 83 percent of the matter in the universe and plays a central role in cosmology modeling. This paper argues that an analogous form of dark matter plays a similarly important role in international macroeconomics. Like its cosmological counterpart, exchange-rate dark matter cannot be directly observed, but its existence can be inferred from observations on the real exchange rates and interest rates. In the first part of this paper I show that dark matter is the dominant driver of short- and medium-term changes in real exchange rates for the G-7 countries; accounting for more than 90 percent of the variance at the five-year horizon. Although standard models stress the role of real interest differentials as the proximate drivers of real exchange-rate variations, my findings indicate that they are empirically unimportant. To understand the nature of exchange-rate dark matter, the second part of the paper develops an open-economy DSGE model in which the risk shocks driving households' habits interact with collateral constraints and incomplete markets. The model not only shows that risk shocks can account for the role of dark matter as a driver of real exchange-rate dynamics, but also that these same shocks have significant macroeconomic implications. My analysis suggests that exchange rates appear disconnected from traditional macroeconomic fundamentals because they are particularly susceptible to risk shocks that play an important role in international macroeconomics