Exchange Rate Puzzles: Evidence from Rigidly Fixed Nominal Exchange Rate Systems

49 Pages Posted: 5 Sep 2019

See all articles by Charles M. Engel

Charles M. Engel

University of Wisconsin - Madison - Department of Economics; National Bureau of Economic Research (NBER); University of Washington - Department of Economics

Feng Zhu

Ant Financial

Date Written: August 9, 2019

Abstract

We examine several major exchange rate puzzles: the excess volatility of real exchange rates; their excess reaction to the real interest rate differentials; the uncovered interest rate parity (UIP) puzzle; the excess persistence of real exchange rates; the exchange rate disconnect puzzle; and the consumption correlation puzzle. We examine the behaviour of real exchange rates among pairs of economies that have rigidly fixed nominal exchange rates, eg countries within the euro area, regions in China and Canada, and Hong Kong SAR vis-à-vis the United States, compared with that among non-euro-area OECD economies.

Our results suggest that some of these puzzles are less puzzling under a rigidly fixed exchange rate regime. In particular, real exchange rates appear to have no or little excess volatility; excess reaction of the real exchange rate to real interest rates is less common; there is less disconnect between the real exchange rate and the economic fundamentals; and uncovered interest rate parity appears to hold more frequently in these economies. However, real exchange rates are as persistent in these economies as in the floating rate economies and there appears to be little difference in risk-sharing across countries with fixed versus floating nominal exchange rates. These results may have implications for exchange rate modelling.

Keywords: consumption correlation puzzle, excess volatility, exchange rate disconnect, exchange rate regime, real exchange rate, purchasing power parity, uncovered interest rate parity

JEL Classification: E43, F31

Suggested Citation

Engel, Charles M. and Zhu, Feng, Exchange Rate Puzzles: Evidence from Rigidly Fixed Nominal Exchange Rate Systems (August 9, 2019). BIS Working Paper No. 805, Available at SSRN: https://ssrn.com/abstract=3436207

Charles M. Engel (Contact Author)

University of Wisconsin - Madison - Department of Economics ( email )

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Feng Zhu

Ant Financial ( email )

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