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What drives the exchange rate?

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  • Itskhoki, Oleg
  • Mukhin, Dmitry

Abstract

We use a general open-economy wedge-accounting framework to characterize the set of shocks that can account for major exchange rate puzzles. Focusing on a near-autarky behavior of the economy, we show analytically that all standard macro economic shocks—including productivity, monetary, government spending, and markup shocks—are inconsistent with the broad properties of the macro exchange rate disconnect. News shocks about future macro economic fundamentals can generate plausible exchange rate properties. However, they show up prominently in contemporaneous asset prices, which violates the finance exchange rate disconnect. International shocks to trade costs, terms of trade and import demand, while potentially consistent with disconnect, do not robustly generate the empirical Backus–Smith, UIP and terms-of-trade properties. In contrast, the observed exchange rate behavior is consistent with risk-sharing (financial) shocks that arise from shifts in demand of foreign investors for home-currency assets, or vice versa.

Suggested Citation

  • Itskhoki, Oleg & Mukhin, Dmitry, 2024. "What drives the exchange rate?," LSE Research Online Documents on Economics 123704, London School of Economics and Political Science, LSE Library.
    • Handle: RePEc:ehl:lserod:123704
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    File URL: https://researchonline.lse.ac.uk/id/eprint/123704/
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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