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Exchange-rate volatility, exchange-rate disconnect, and the failure of volatility conservation

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Author Info
Alexei Deviatov () (New Economic School)
Igor Dodonov (New Economic School)
Abstract

Empirical analysis of exchange rates has produced puzzles that conventional models of exchange rates cannot explain. Here we deal with four puzzles regarding both real and nominal exchange rates, which are robust and inconsistent with standard theory. These puzzles are that both real and nominal exchange rates: i) are disconnected from fundamentals, ii) are much more volatile than fundamentals, iii) show little di?erence in behavior, and iv) fail to satisfy conservation of volatility. We develop a two-country, two-currency version of the random matching model to study exchange rates. We show that search and legal restrictions can produce exchange-rate dynamics consistent with these four puzzles.

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Publisher Info
Paper provided by Center for Economic and Financial Research (CEFIR) in its series Working Papers with number w0079.

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Length: 36 pages
Date of creation: Jun 2006
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Handle: RePEc:cfr:cefirw:w0079

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Related research
Keywords: exchange-rate puzzles; exchange-rate volatility; bargaining; search;

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
C78 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Bargaining Theory; Matching Theory

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  14. Shleifer, Andrei & Summers, Lawrence H, 1990. "The Noise Trader Approach to Finance," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 19-33, Spring. [Downloadable!] (restricted)
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  20. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March. [Downloadable!] (restricted)
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