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Exchange rate pass-through, exchange rate volatility, and exchange rate disconnect

  • Devereux, Michael B.
  • Engel, Charles

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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Article provided by Elsevier in its journal Journal of Monetary Economics.

Volume (Year): 49 (2002)
Issue (Month): 5 (July)
Pages: 913-940

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Handle: RePEc:eee:moneco:v:49:y:2002:i:5:p:913-940
Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505566

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  1. Geert Bekaert & Robert J. Hodrick & David A. Marshall, 1994. "The implications of first-order risk aversion for asset market risk premiums," Working Paper Series, Macroeconomic Issues 94-22, Federal Reserve Bank of Chicago.
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  5. 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 427-70.
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  8. 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.
  9. Charles Engel, 2001. "Optimal exchange rate policy: the influence of price setting and asset markets," Proceedings, Federal Reserve Bank of Cleveland, pages 518-547.
  10. Jeffrey A. Frankel, 1993. "On Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061546, June.
  11. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," CEPR Discussion Papers 1131, C.E.P.R. Discussion Papers.
  12. Margarida Duarte & Alan C. Stockman, 2001. "Rational Speculation and Exchange Rates," NBER Working Papers 8362, National Bureau of Economic Research, Inc.
  13. 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.
  14. 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, vol. 69(3), pages 533-63, July.
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  19. 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.
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  23. repec:dgr:kubcen:199707 is not listed on IDEAS
  24. Frankel, Jeff & Froot, Ken, 1986. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," Department of Economics, Working Paper Series qt1972q8wm, Department of Economics, Institute for Business and Economic Research, UC Berkeley.
  25. Engel, Charles, 1993. "Real exchange rates and relative prices : An empirical investigation," Journal of Monetary Economics, Elsevier, vol. 32(1), pages 35-50, August.
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