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A Gravity View of Exchange Rate Disconnect

  • Fitzgerald, Doireann
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    The empirical “gravity†equation is extremely successful in explaining bilateral trade. This paper shows how a multi-country model of specialization and costly trade (i.e. a microfounded gravity model) can be applied to explain empirical exchange rate puzzles. One such puzzle is the fact that nominal exchange rates are enormously volatile, but that this volatility does not appear to affect inflation. The gravity model is very successful in explaining this puzzle. In a sample of 25 OECD countries in the post- Bretton Woods period, the gravity prediction of inflation substantially outperforms the purchasing power parity prediction. The gravity prediction matches the volatility of actual inflation, and tracks its path closely. The superior performance of the gravity prediction is explained primarily by the fact that it takes account of the interaction of specialization with home bias. The stability of inflation in very open economies is explained in addition by the fact that the size of bilateral trade is negatively correlated with bilateral exchange rate volatility.

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    Paper provided by Department of Economics, UC Santa Cruz in its series Santa Cruz Department of Economics, Working Paper Series with number qt05121869.

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    Date of creation: 01 Nov 2004
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    Handle: RePEc:cdl:ucscec:qt05121869
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    1. Fabio Ghironi & Marc J. Melitz, 2004. "International Trade and Macroeconomic Dynamics with Heterogeneous Firms," Boston College Working Papers in Economics 599, Boston College Department of Economics.
    2. Philip R. Lane, & Patrick Honohan, 2003. "Divergent Inflation Rates in EMU," The Institute for International Integration Studies Discussion Paper Series iiisdp05, IIIS.
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    5. Corsetti, Giancarlo & Dedola, Luca, 2002. "Macroeconomics of international price discrimination," Working Paper Series 0176, European Central Bank.
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    7. Maurice Obstfeld & Kenneth Rogoff, 2001. "The Six Major Puzzles in International Macroeconomics: Is There a Common Cause?," NBER Chapters, in: NBER Macroeconomics Annual 2000, Volume 15, pages 339-412 National Bureau of Economic Research, Inc.
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    9. Hau, Harald, 2002. "Real Exchange Rate Volatility and Economic Openness: Theory and Evidence," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 34(3), pages 611-30, August.
    10. Charles Engel, 1995. "Accounting for U.S. Real Exchange Rate Changes," NBER Working Papers 5394, National Bureau of Economic Research, Inc.
    11. Paul R. Bergin & Reuven Glick, 2003. "Endogenous Tradability and Macroeconomic Implications," NBER Working Papers 9739, National Bureau of Economic Research, Inc.
    12. Campa, José Manuel & Goldberg, Linda S., 2004. "Exchange Rate Pass-Through into Import Prices," CEPR Discussion Papers 4391, C.E.P.R. Discussion Papers.
    13. Christian Broda & John Romalis, 2011. "Identifying the Relationship Between Trade and Exchange Rate Volatility," NBER Chapters, in: Commodity Prices and Markets, East Asia Seminar on Economics, Volume 20, pages 79-110 National Bureau of Economic Research, Inc.
    14. Jeffrey A. Frankel and Shang-Jin Wei., 1993. "Emerging Currency Blocs," Center for International and Development Economics Research (CIDER) Working Papers C93-026, University of California at Berkeley.
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