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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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  17. Michael Devereux & Charles Engel & Cedric Tille, 1999. "Exchange-Rate Pass-Through and the Welfare Effects of the Euro," Working Papers 0034, University of Washington, Department of Economics.
  18. Olivier Jeanne & Andrew K. Rose, 1999. "Noise Trading and Exchange Rate Regimes," NBER Working Papers 7104, National Bureau of Economic Research, Inc.
  19. Flood, Robert P. & Rose, Andrew K., 1995. "Fixing exchange rates A virtual quest for fundamentals," Journal of Monetary Economics, Elsevier, vol. 36(1), pages 3-37, August.
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