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Understanding the sources of the exchange rate disconnect puzzle: A variance decomposition approach

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  • Chou, Yu-Hsi

Abstract

In this paper, we apply the monetary model to examine the degree to which economic fundamentals can explain large and persistent fluctuations in the spread between the nominal exchange rate and monetary fundamentals i.e. the so-called “exchange rate disconnect puzzle.” We show that deviations from purchasing power parity account for the bulk of the variation in the deviations of the nominal exchange rate from observed monetary fundamentals, whereas the importance of the risk premium becomes more pronounced after the establishment of the European Economic and Monetary Union.

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  • Chou, Yu-Hsi, 2018. "Understanding the sources of the exchange rate disconnect puzzle: A variance decomposition approach," International Review of Economics & Finance, Elsevier, vol. 56(C), pages 267-287.
    • Handle: RePEc:eee:reveco:v:56:y:2018:i:c:p:267-287
    DOI: 10.1016/j.iref.2017.10.029
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    More about this item

    Keywords

    Monetary fundamentals; Exchange rate disconnect puzzle; Variance decomposition;
    All these keywords.

    JEL classification:

    • C5 - Mathematical and Quantitative Methods - - Econometric Modeling
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F47 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Forecasting and Simulation: Models and Applications

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