Mussa Puzzle Redux

51 Pages Posted: 23 Jul 2019

See all articles by Oleg Itskhoki

Oleg Itskhoki

Princeton University - Department of Economics

Dmitry Mukhin

University of Wisconsin Madison

Multiple version iconThere are 2 versions of this paper

Date Written: July 20, 2019


The Mussa (1986) puzzle - a sharp and simultaneous increase in the volatility of both nominal and real exchange rates after the end of the Bretton Woods System of pegged exchange rates in early 1970s - is commonly viewed as a central piece of evidence in favor of monetary non-neutrality. Indeed, a change in the em monetary regime has caused a dramatic change in the equilibrium behavior of a real variable - the real exchange rate. The Mussa fact is further interpreted as direct evidence in favor of models with nominal rigidities in price setting (sticky prices). We show that this last conclusion is not supported by the data, as there was no simultaneous change in the properties of the other macro variables - neither nominal like inflation, nor real like consumption, output or net exports. We show that the extended set of Mussa facts equally falsifies both conventional flexible-price RBC models and sticky-price New Keynesian models. We present a resolution to this broader puzzle based on a model of segmented financial market - a particular type of financial friction by which the bulk of the nominal exchange rate risk is held by a small group of financial intermediaries and not shared smoothly throughout the economy. We argue that rather than discriminating between models with sticky versus flexible prices, or monetary versus productivity shocks, the Mussa puzzle provides sharp evidence in favor of models with monetary non-neutrality arising due to financial market segmentation. Sticky prices are neither necessary, nor sufficient for the qualitative success of the model, yet improve its quantitative fit on the margin.

Keywords: Mussa puzzle, exchange rates, monetary policy

JEL Classification: E5, F3, F4

Suggested Citation

Itskhoki, Oleg and Mukhin, Dmitry, Mussa Puzzle Redux (July 20, 2019). Available at SSRN: or

Oleg Itskhoki

Princeton University - Department of Economics ( email )

Fisher 306
Princeton, NJ 08544-1021
United States
+1 (609) 258-5493 (Phone)


Dmitry Mukhin (Contact Author)

University of Wisconsin Madison ( email )

United States

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