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Exchange-rate volatility, exchange-rate disconnect, and the failure of volatility conservation

  • Alexei Deviatov

    ()

    (New Economic School)

  • Igor Dodonov

    (New Economic School)

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    Empirical analysis of exchange rates has produced puzzles that conventional models of exchange rates cannot explain. Here we deal with four puzzles regarding both real and nominal exchange rates, which are robust and inconsistent with standard theory. These puzzles are that both real and nominal exchange rates: i) are disconnected from fundamentals, ii) are much more volatile than fundamentals, iii) show little di?erence in behavior, and iv) fail to satisfy conservation of volatility. We develop a two-country, two-currency version of the random matching model to study exchange rates. We show that search and legal restrictions can produce exchange-rate dynamics consistent with these four puzzles.

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    Paper provided by Center for Economic and Financial Research (CEFIR) in its series Working Papers with number w0079.

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    Length: 36 pages
    Date of creation: Jun 2006
    Date of revision:
    Handle: RePEc:cfr:cefirw:w0079
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