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Exchange Rate Pass-Through, Exchange Rate Volatility, and ExchangeRate Disconnect

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  • M.B. Devereux
  • Ch. Engel

Abstract

This paper explores the hypothesis that high volatility of real and nominal exchange rates may be due to the fact that local currency pricing eliminates the pass-through from changes in exchange rates to consumer prices. Exchange rates may be highly volatile because in a sense they have little effect on macroeconomic variables. The paper shows the ingredients necessary to construct such an explanation for exchange rate volatility. In addition to the presence of local currency pricing, we need a) incomplete international financial markets, b) a structure of international pricing and product distribution such that wealth effects of exchange rate changes are minimized, and c) stochastic deviations from uncovered interest rate parity. Together, it is shown that these elements can produce exchange rate volatility that is much higher than shocks to economic fundamentals, and 'disconnected' from the rest of the economy in the sense that the volatility of all other macroeconomic aggregates are of the same order as that of fundamentals.

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File URL: http://www.dnb.nl/binaries/sr077_tcm46-146854.pdf
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Bibliographic Info

Paper provided by Netherlands Central Bank in its series DNB Staff Reports (discontinued) with number 77.

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Length: 49 pages
Date of creation: 2003
Date of revision:
Handle: RePEc:dnb:staffs:77

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Keywords: exchange rate pass-through; exchange rate volatility; exchange rate disconnect; local currency pricing; noise traders;

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References

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  1. Flood, R.P. & Rose, A.K., 1992. "Fixing Exchange Rates: A Virtual Quest for Fundamentals," Papers, Stockholm - International Economic Studies 529, Stockholm - International Economic Studies.
  2. Kenneth A. Froot and Jeffrey A. Frankel., 1988. "Forward Discount Bias: Is It an Exchange Risk Premium?," Economics Working Papers, University of California at Berkeley 8874, University of California at Berkeley.
  3. Chari, V V & Kehoe, Patrick J & McGrattan, Ellen R, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 69(3), pages 533-63, July.
  4. Michael Devereux & Charles Engel, 2000. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange Rate Flexibiity," Working Papers, University of Washington, Department of Economics 0016, University of Washington, Department of Economics.
  5. McCallum, Bennett T & Nelson, Edward, 2000. "Monetary Policy for an Open Economy: An Alternative Framework with Optimizing Agents and Sticky Prices," Oxford Review of Economic Policy, Oxford University Press, vol. 16(4), pages 74-91, Winter.
  6. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-53, March.
  7. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
  8. Jeanne, Olivier & Rose, Andrew K, 1999. "Noise Trading and Exchange Rate Regimes," CEPR Discussion Papers 2142, C.E.P.R. Discussion Papers.
  9. Charles Engel, 1995. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
  10. Charles Engel, 2000. "Optimal Exchange Rate Policy:The Influence of Price-Setting and Asset Markets," Working Papers, University of Washington, Department of Economics 0020, University of Washington, Department of Economics.
  11. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers.
  12. Michael B. Devereux & Charles Engel & CÈdric Tille, 2003. "Exchange Rate Pass-Through and the Welfare Effects of the Euro," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 44(1), pages 223-242, February.
  13. Marianne Baxter & Alan C. Stockman, 1988. "Business Cycles and the Exchange Rate System: Some International Evidence," NBER Working Papers 2689, National Bureau of Economic Research, Inc.
  14. Obstfeld, Maurice, 2001. "International Macroeconomics: Beyond the Mundell-Fleming Model," Center for International and Development Economics Research, Working Paper Series, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkele qt6796n8s0, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  15. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
  16. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, American Finance Association, vol. 56(1), pages 279-304, 02.
  17. Jeffrey A. Frankel, 1993. "On Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061546, December.
  18. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
  19. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1994. "The Implications of First-Order Risk Aversion for Asset Market Risk Premiums," NBER Working Papers 4624, National Bureau of Economic Research, Inc.
  20. Geert Bekaert, 1994. "The Time Variation of Risk and Return in Foreign Exchange Markets: A General Equilibrium Perspective," NBER Working Papers 4818, National Bureau of Economic Research, Inc.
  21. Moore, Michael J. & Roche, Maurice J., 2002. "Less of a puzzle: a new look at the forward forex market," Journal of International Economics, Elsevier, vol. 58(2), pages 387-411, December.
  22. Eric van Wincoop & Philippe Bacchetta, 2000. "Does Exchange-Rate Stability Increase Trade and Welfare?," American Economic Review, American Economic Association, vol. 90(5), pages 1093-1109, December.
  23. Jeffrey A. Frankel & Kenneth A. Froot, 1985. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc.
  24. Charles Engel, 1992. "Real Exchange Rates and Relative Prices: An Empirical Investigation," NBER Working Papers 4231, National Bureau of Economic Research, Inc.
  25. Duarte, Margarida & Stockman, Alan C., 2005. "Rational speculation and exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 52(1), pages 3-29, January.
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