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A Gravity View of Exchange Rate Disconnect

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  • Fitzgerald, Doireann
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    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.

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    Bibliographic Info

    Paper provided by Department of Economics, UC Santa Cruz in its series Santa Cruz Department of Economics, Working Paper Series with number qt05121869.

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    Date of creation: 01 Nov 2004
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    Handle: RePEc:cdl:ucscec:qt05121869

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    Keywords: Exchange rate disconnect; Trade; Gravity equation;

    References

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    1. Maurice Obstfeld & Kenneth Rogoff & Ben Bernanke & Kenneth Rogoff, . "The Six Major Puzzles in International Macroeconomics: Is there a Common Cause?," Working Paper, Harvard University OpenScholar 32326, Harvard University OpenScholar.
    2. Ariel T. Burstein & Joao C. Neves & Sergio Rebelo, 2000. "Distribution Costs and Real Exchange Rate Dynamics During Exchange-Rate-Based-Stabilizations," NBER Working Papers, National Bureau of Economic Research, Inc 7862, National Bureau of Economic Research, Inc.
    3. Jeffrey A. Frankel & Shang-Jin Wei, 1993. "Emerging Currency Blocs," NBER Working Papers, National Bureau of Economic Research, Inc 4335, National Bureau of Economic Research, Inc.
    4. Ghironi, Fabio & Melitz, Marc, 2005. "International Trade and Macroeconomic Dynamics with Heterogeneous Firms," Scholarly Articles, Harvard University Department of Economics 3228377, Harvard University Department of Economics.
    5. Charles Engel & John H. Rogers, 1996. "Regional patterns in the law of one price: the roles of geography vs. currencies," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 533, Board of Governors of the Federal Reserve System (U.S.).
    6. Corsetti, Giancarlo & Dedola, Luca, 2002. "Macroeconomics of international price discrimination," Working Paper Series, European Central Bank 0176, European Central Bank.
    7. José Manuel Campa & Linda S. Goldberg, 2005. "Exchange Rate Pass-Through into Import Prices," The Review of Economics and Statistics, MIT Press, MIT Press, vol. 87(4), pages 679-690, November.
    8. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Discussion Papers in Economics at the University of Washington, Department of Economics at the University of Washington 96-02, Department of Economics at the University of Washington.
    9. Philip R. Lane & Patrick Honohan, 2003. "Divergent Inflation Rates in EMU," Trinity Economics Papers, Trinity College Dublin, Department of Economics 20034, Trinity College Dublin, Department of Economics.
    10. Christian Broda & John Romalis, 2011. "Identifying the Relationship Between Trade and Exchange Rate Volatility," NBER Chapters, National Bureau of Economic Research, Inc, in: Commodity Prices and Markets, East Asia Seminar on Economics, Volume 20, pages 79-110 National Bureau of Economic Research, Inc.
    11. Papell, David H & Theodoridis, Hristos, 2001. "The Choice of Numeraire Currency in Panel Tests of Purchasing Power Parity," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 33(3), pages 790-803, August.
    12. Jonathan Eaton & Samuel Kortum, 2002. "Technology, Geography, and Trade," Econometrica, Econometric Society, Econometric Society, vol. 70(5), pages 1741-1779, September.
    13. Paul R. Bergin & Reuven Glick, 2003. "Endogenous Tradability and Macroeconomic Implications," NBER Working Papers, National Bureau of Economic Research, Inc 9739, National Bureau of Economic Research, Inc.
    14. Hau, Harald, 2002. "Real Exchange Rate Volatility and Economic Openness: Theory and Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 34(3), pages 611-30, August.
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    Cited by:
    1. Andrew Atkeson & Ariel Burstein, 2008. "Pricing-to-market, trade costs, and international relative prices," Staff Report, Federal Reserve Bank of Minneapolis 404, Federal Reserve Bank of Minneapolis.

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