Mussa Puzzle Redux

62 Pages Posted: 14 Jul 2021

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: June 2021

Abstract

The Mussa (1986) puzzle is the observation of a sharp and simultaneous increase in the volatility of both nominal and real exchange rates following the end of the Bretton Woods System of pegged exchange rates in 1973. It is commonly viewed as a central piece of evidence in favor of monetary non-neutrality because it is an instance in which a change in the monetary regime caused a dramatic change in the equilibrium behavior of a real variable (the real exchange rate) and is often further interpreted as direct evidence in favor of models with nominal rigidities in price setting. This paper shows that the data do not support this latter conclusion because there was no simultaneous change in the properties of the other macro variables, nominal or real. We show that an extended set of Mussa facts equally falsifies both conventional flexible-price RBC models and sticky-price New Keynesian models as explanations for the Mussa puzzle. We present a resolution to the broader Mussa 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 financial intermediaries and is 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 in the financial market, suggesting the importance of monetary transmission via the risk premium channel.

JEL Classification: E30, E40, E50, F30, F40, G10

Suggested Citation

Itskhoki, Oleg and Mukhin, Dmitry, Mussa Puzzle Redux (June 2021). CEPR Discussion Paper No. DP16301, Available at SSRN: https://ssrn.com/abstract=3886774

Oleg Itskhoki (Contact Author)

Princeton University - Department of Economics ( email )

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

HOME PAGE: http://www.princeton.edu/~itskhoki

Dmitry Mukhin

University of Wisconsin Madison ( email )

WI
United States

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