A Gravity View of Exchange Rate Disconnect

UC Santa Cruz International Economics Working Paper No. 04-19; UC Santa Cruz Economics Working Paper No. 580

41 Pages Posted: 22 Nov 2004

See all articles by Doireann Fitzgerald

Doireann Fitzgerald

Federal Reserve Banks - Federal Reserve Bank of Minneapolis

Date Written: November 2004

Abstract

The empirical "gravity" equation is extremely successful in explaining bilateral trade. This paper shows how a multi-country model of specialization and costly trade (i.e. a microfounded gravity model) can be applied to explain empirical exchange rate puzzles. One such puzzle is the fact that nominal exchange rates are enormously volatile, but that this volatility does not appear to affect inflation. The gravity model is very successful in explaining this puzzle. In a sample of 25 OECD countries in the post-Bretton Woods period, the gravity prediction of inflation substantially outperforms the purchasing power parity prediction. The gravity prediction matches the volatility of actual inflation, and tracks its path closely. The superior performance of the gravity prediction is explained primarily by the fact that it takes account of the interaction of specialization with home bias. The stability of inflation in very open economies is explained in addition by the fact that the size of bilateral trade is negatively correlated with bilateral exchange rate volatility.

Keywords: Exchange rate disconnect, trade, gravity equation

JEL Classification: F12, F31, F41

Suggested Citation

Fitzgerald, Doireann, A Gravity View of Exchange Rate Disconnect (November 2004). UC Santa Cruz International Economics Working Paper No. 04-19; UC Santa Cruz Economics Working Paper No. 580, Available at SSRN: https://ssrn.com/abstract=596702 or http://dx.doi.org/10.2139/ssrn.596702

Doireann Fitzgerald (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Minneapolis ( email )

90 Hennepin Avenue
Minneapolis, MN 55480
United States

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