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Exchange Rate Disconnect in General Equilibrium

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  • Oleg Itskhoki
  • Dmitry Mukhin

Abstract

We propose a dynamic general equilibrium model of exchange rate determination that accounts for all major exchange rate puzzles, including Meese-Rogoff, Backus-Smith, purchasing power parity, and uncovered interest rate parity puzzles. We build on a standard international real business cycle model with home bias in consumption, augmented with shocks in the financial market that result in a volatile near-martingale behavior of exchange rates and ensure their empirically relevant comovement with macroeconomic variables, both nominal and real. Combining financial shocks with conventional productivity and monetary shocks allows the model to reproduce the exchange rate disconnect properties without compromising the fit of the business cycle moments.

Suggested Citation

  • Oleg Itskhoki & Dmitry Mukhin, 2021. "Exchange Rate Disconnect in General Equilibrium," Journal of Political Economy, University of Chicago Press, vol. 129(8), pages 2183-2232.
  • Handle: RePEc:ucp:jpolec:doi:10.1086/714447
    DOI: 10.1086/714447
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    JEL classification:

    • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
    • F30 - International Economics - - International Finance - - - General
    • F4 - International Economics - - Macroeconomic Aspects of International Trade and Finance

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