Market Incompleteness and Exchange Rate Spill-Over
46 Pages Posted: 23 Jan 2023 Last revised: 6 Feb 2023
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Market Incompleteness and Exchange Rate Spill-over
Date Written: January 2023
I develop a general characterization of the effect that market incompleteness has on exchange rate dynamics. On the one hand, it weakens the pass-through from a country's marginal utility shocks to its own exchange rate movements; on the other hand, it gives rise to additional variations in exchange rates and propagates one country's marginal utility shocks to other countries' exchange rate movements. This novel international spill-over effect gives rise to both exchange rate disconnect from local fundamentals and exchange rate comovements in the cross-section of currencies, offering a novel channel for understanding these salient features of exchange rate behaviors.
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