Transaction Costs, Nonfundamental Uncertainty, And The Exchange Rate Disconnect

Exchange rates display excessive volatility and are disconnected from macroeconomic fundamentals. This paper presents a two-country general equilibrium model in which nonfundamental uncertainty (“sunspots”) in part drives stochastic fluctuations in the exchange rate in a class of rational expectation equilibria. In the model, a combination of financial frictions—incomplete asset markets and a proportional transaction cost associated with trading foreign-currency-denominated bonds—breaks the tight link between exchange rates and fundamentals. Moreover, the model generates a negative Backus–Smith correlation between relative consumption and the real exchange rate, because relative prices, acting as a source of shocks as opposed to shock absorbers, directly affect relative output and generate a large wealth effect on relative consumption. Using a random walk as an example of sunspot shocks, the volatility of exchange rates relative to that of output and consumption is found to be large in the presence of nontradable goods and distribution services.