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

7 Pages Posted: 14 Jul 2016

See all articles by Charles Yuji Horioka

Charles Yuji Horioka

Kobe University; National Bureau of Economic Research; Asian Growth Research Institute; Osaka University

Nicholas Ford

University of Cambridge - Wolfson College

Date Written: July 13, 2016

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.

Keywords: Exchange Rate Disconnect Puzzle, exchange rate determination and volatility, Feldstein-Horioka puzzle or paradox, financial market integration, goods market integration, net transfers of capital, PPP puzzle, real interest rate equalisation

JEL Classification: F21, F31, F32, F36, G15

Suggested Citation

Horioka, Charles Yuji and Ford, Nicholas, A Possible Explanation of the ‘Exchange Rate Disconnect Puzzle’: A Common Solution to Three Major Macroeconomic Puzzles? (July 13, 2016). ISER Discussion Paper No. 977, Available at SSRN: https://ssrn.com/abstract=2809488 or http://dx.doi.org/10.2139/ssrn.2809488

Charles Yuji Horioka (Contact Author)

Kobe University ( email )

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National Bureau of Economic Research ( email )

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United States

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Asian Growth Research Institute ( email )

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Japan

HOME PAGE: http://www.iser.osaka-u.ac.jp

Osaka University ( email )

6-1, Mihogaoka
Suita, Osaka 567-0047
Japan

HOME PAGE: http://www.rieb.kobe-u.ac.jp

Nicholas Ford

University of Cambridge - Wolfson College ( email )

Barton Road
Cambridge, CB3 9BB
United Kingdom

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