IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Log in (now much improved!) to save this article

Solving exchange rate puzzles with neither sticky prices nor trade costs

Listed author(s):
  • Moore, Michael J.
  • Roche, Maurice J.

We present a simple framework in which both the exchange rates disconnect and forward bias puzzles are simultaneously resolved. The flexible-price two-country monetary model is extended to include a consumption externality with habit persistence. Habit persistence is modeled using Campbell Cochrane preferences with 'deep' habits along the lines of the work of Ravn, Schmitt-Grohe and Uribe. By deep habits, we mean habits defined over goods rather than countries. The model is simulated using the artificial economy methodology. It offers a neo-classical explanation of the Meese-Rogoff puzzle and mimics the failure of fundamentals to explain nominal exchange rates in a linear setting. Finally, the model naturally generates the negative slope in the standard forward market regression.

If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

File URL: http://www.sciencedirect.com/science/article/pii/S0261-5606(10)00034-3
Download Restriction: Full text for ScienceDirect subscribers only

As the access to this document is restricted, you may want to look for a different version under "Related research" (further below) or search for a different version of it.

Article provided by Elsevier in its journal Journal of International Money and Finance.

Volume (Year): 29 (2010)
Issue (Month): 6 (October)
Pages: 1151-1170

as
in new window

Handle: RePEc:eee:jimfin:v:29:y:2010:i:6:p:1151-1170
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30443

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

as in new window
  1. Backus, David K., 1993. "Interpreting comovements in the trade balance and the terms of trade," Journal of International Economics, Elsevier, vol. 34(3-4), pages 375-387, May.
  2. Morten Ravn & Stephanie Schmitt-Grohé & Martín Uribe, 2006. "Deep Habits," Review of Economic Studies, Oxford University Press, vol. 73(1), pages 195-218.
  3. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1992. "International Real Business Cycles," Journal of Political Economy, University of Chicago Press, vol. 100(4), pages 745-775, August.
  4. Charles Engel, 1990. "On the foreign exchange risk premium in a general equilibrium model," Research Working Paper 90-06, Federal Reserve Bank of Kansas City.
  5. Adrien Verdelhan, 2006. "A Habit-Based Explanation of the Exchange Rate Risk Premium," 2006 Meeting Papers 872, Society for Economic Dynamics.
  6. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 01-90, Wharton School Rodney L. White Center for Financial Research.
  7. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  8. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," International Trade 0012003, EconWPA.
  9. Charles Engel, 1999. "On the Foreign-Exchange Risk Premium in Sticky-Price General Equilibrium Models," NBER Working Papers 7067, National Bureau of Economic Research, Inc.
  10. Thomas F. Crossley & Hamish W. Low, 2011. "Is The Elasticity Of Intertemporal Substitution Constant?," Journal of the European Economic Association, European Economic Association, vol. 9(1), pages 87-105, 02.
  11. Maurice J. Roche & Michael J. Moore, "undated". "Less of a puzzle: a new look at the forward forex market," Economics, Finance and Accounting Department Working Paper Series n, Department of Economics, Finance and Accounting, National University of Ireland - Maynooth.
  12. Martin D.D. Evans & Richard K. Lyons, 1999. "Order Flow and Exchange Rate Dynamics," NBER Working Papers 7317, National Bureau of Economic Research, Inc.
  13. Bekaert, Geert, 1996. "The Time Variation of Risk and Return in Foreign Exchange Markets: A General Equilibrium Perspective," Review of Financial Studies, Society for Financial Studies, vol. 9(2), pages 427-470.
  14. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  15. Olivier Jeanne & Andrew K. Rose, 2002. "Noise Trading and Exchange Rate Regimes," The Quarterly Journal of Economics, Oxford University Press, vol. 117(2), pages 537-569.
  16. Lucio Sarno, 2005. "Viewpoint: Towards a solution to the puzzles in exchange rate economics: where do we stand?," Canadian Journal of Economics, Canadian Economics Association, vol. 38(3), pages 673-708, August.
  17. Bansal, Ravi & Dahlquist, Magnus, 2000. "The forward premium puzzle: different tales from developed and emerging economies," Journal of International Economics, Elsevier, vol. 51(1), pages 115-144, June.
  18. Faust, Jon & Rogers, John H. & H. Wright, Jonathan, 2003. "Exchange rate forecasting: the errors we've really made," Journal of International Economics, Elsevier, vol. 60(1), pages 35-59, May.
  19. Ravn, Morten O & Schmitt-Grohé, Stephanie & Uribe, Martín, 2007. "Pricing to Habits and the Law of One Price," CEPR Discussion Papers 6030, C.E.P.R. Discussion Papers.
  20. Backus, David K & Kehoe, Patrick J & Kydland, Finn E, 1994. "Dynamics of the Trade Balance and the Terms of Trade: The J-Curve?," American Economic Review, American Economic Association, vol. 84(1), pages 84-103, March.
  21. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
  22. Clark, Andrew E & Oswald, Andrew J, 1993. "Satisfaction and Comparison Income," Economics Discussion Papers 10018, University of Essex, Department of Economics.
  23. G. Constantinides, 1990. "Habit formation: a resolution of the equity premium puzzle," Levine's Working Paper Archive 1397, David K. Levine.
  24. Gourinchas, P.O. & Parker, J.A., 1997. "Consumption Over the Life Cycle," Working papers 9722, Wisconsin Madison - Social Systems.
  25. Feenstra, Robert C., 1986. "Functional equivalence between liquidity costs and the utility of money," Journal of Monetary Economics, Elsevier, vol. 17(2), pages 271-291, March.
  26. David K. Backus & Allan W. Gregory & Chris I. Telmer, 1990. "Accounting for Forward Rates in Markets for Foreign Currency," Working Papers 792, Queen's University, Department of Economics.
  27. Fernando Alvarez & Andrew Atkeson & Patrick J. Kehoe, 2005. "Time-varying risk, interest rates and exchange rates in general equilibrium," Working Papers 627, Federal Reserve Bank of Minneapolis.
  28. Paul R. Bergin & Robert C. Feenstra, "undated". "Pricing To Market, Staggered Contracts, And Real Exchange Rate Persistence," Department of Economics 99-01, California Davis - Department of Economics.
  29. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
  30. Hau, Harald, 1998. "Competitive Entry and Endogenous Risk in the Foreign Exchange Market," Review of Financial Studies, Society for Financial Studies, vol. 11(4), pages 757-787.
  31. John A Carlson & Christian M. Dahl & Carol L. Osler, 2008. "Short-run Exchange-Rate Dynamics: Theory and Evidence," CREATES Research Papers 2008-01, Department of Economics and Business Economics, Aarhus University.
  32. Jeffrey Frankel & Jumana Poonawala, 2006. "The Forward Market in Emerging Currencies: Less Biased Than in Major Currencies," NBER Working Papers 12496, National Bureau of Economic Research, Inc.
  33. Moore, Michael J. & Roche, Maurice J., 2008. "Volatile and persistent real exchange rates with or without sticky prices," Journal of Monetary Economics, Elsevier, vol. 55(2), pages 423-433, March.
  34. Philippe Bacchetta & Eric van Wincoop, 2005. "Rational Inattention: A Solution to the Forward Discount Puzzle," FAME Research Paper Series rp156, International Center for Financial Asset Management and Engineering.
  35. Moore, Michael J, 1992. "Covered Purchasing Power Parity, Ex-Ante PPP and Risk Aversion," CEPR Discussion Papers 635, C.E.P.R. Discussion Papers.
  36. Flood, Robert P & Rose, Andrew K, 1998. "Understanding Exchange Rate Volatility Without the Contrivance of Macroeconomics," CEPR Discussion Papers 1944, C.E.P.R. Discussion Papers.
  37. Oswald, Andrew J, 1997. "Happiness and Economic Performance," Economic Journal, Royal Economic Society, vol. 107(445), pages 1815-31, November.
  38. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, vol. 85(1), pages 201-218, March.
  39. Gourinchas, Pierre-Olivier & Tornell, Aaron, 2004. "Exchange rate puzzles and distorted beliefs," Journal of International Economics, Elsevier, vol. 64(2), pages 303-333, December.
  40. Killeen, William P. & Lyons, Richard K. & Moore, Michael J., 2006. "Fixed versus flexible: Lessons from EMS order flow," Journal of International Money and Finance, Elsevier, vol. 25(4), pages 551-579, June.
  41. Fisher, Eric O'N., 2006. "The forward premium in a model with heterogeneous prior beliefs," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 48-70, February.
  42. David K. Backus, 2001. "Affine Term Structure Models and the Forward Premium Anomaly," Journal of Finance, American Finance Association, vol. 56(1), pages 279-304, 02.
  43. Martin D. D. Evans(Georgetown University and NBER) and Richard K. Lyons(U.C. Berkeley and NBER, Haas School of Business), 2005. "A New Micro Model of Exchange Rate Dynamics (March 2004)," Working Papers gueconwpa~05-05-04, Georgetown University, Department of Economics.
  44. James E. Anderson & Eric van Wincoop, 2004. "Trade Costs," NBER Working Papers 10480, National Bureau of Economic Research, Inc.
  45. Mark P. Taylor, 1995. "The Economics of Exchange Rates," Journal of Economic Literature, American Economic Association, vol. 33(1), pages 13-47, March.
  46. Yacine Aït-Sahalia & Jonathan A. Parker & Motohiro Yogo, 2004. "Luxury Goods and the Equity Premium," Journal of Finance, American Finance Association, vol. 59(6), pages 2959-3004, December.
  47. Chinn, Menzie D., 2006. "The (partial) rehabilitation of interest rate parity in the floating rate era: Longer horizons, alternative expectations, and emerging markets," Journal of International Money and Finance, Elsevier, vol. 25(1), pages 7-21, February.
  48. Menzie D. Chinn & Guy Meredith, 2004. "Monetary Policy and Long-Horizon Uncovered Interest Parity," IMF Staff Papers, Palgrave Macmillan, vol. 51(3), pages 409-430, November.
  49. Jacob Boudoukh & Matthew Richardson & Robert Whitelaw, 2005. "The Information in Long-Maturity Forward Rates: Implications for Exchange Rates and the Forward Premium Anomaly," NBER Working Papers 11840, National Bureau of Economic Research, Inc.
  50. Alexius, Annika, 2001. "Uncovered Interest Parity Revisited," Review of International Economics, Wiley Blackwell, vol. 9(3), pages 505-517, August.
  51. Philippe Bacchetta & Eric van Wincoop, 2006. "Incomplete information processing: a solution to the forward discount puzzle," Proceedings, Federal Reserve Bank of San Francisco, issue Jun, pages -.
  52. Mendoza, Enrique G, 1995. "The Terms of Trade, the Real Exchange Rate, and Economic Fluctuations," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 36(1), pages 101-137, February.
  53. Takatoshi Ito, 1997. "Purchasing Power Parity," NBER Books, National Bureau of Economic Research, Inc, number ito_97-2, Enero.
  54. Harald Uhlig & Lars Ljungqvist, 2000. "Tax Policy and Aggregate Demand Management under Catching Up with the Joneses," American Economic Review, American Economic Association, vol. 90(3), pages 356-366, June.
  55. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  56. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
  57. Brandt, Michael W. & Cochrane, John H. & Santa-Clara, Pedro, 2006. "International risk sharing is better than you think, or exchange rates are too smooth," Journal of Monetary Economics, Elsevier, vol. 53(4), pages 671-698, May.
Full references (including those not matched with items on IDEAS)

This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

When requesting a correction, please mention this item's handle: RePEc:eee:jimfin:v:29:y:2010:i:6:p:1151-1170. See general information about how to correct material in RePEc.

For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Shamier, Wendy)

If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

If references are entirely missing, you can add them using this form.

If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

Please note that corrections may take a couple of weeks to filter through the various RePEc services.

This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.