Exchange Rate Disconnect

We propose a general equilibrium model of exchange rate disconnect, which simultaneously accounts for all major puzzles associated with the nominal and real exchange rates. This includes the Meese-Rogoff, the PPP, the terms-of-trade, the Backus-Smith, and the UIP puzzles. The model has two main building blocks --- the driving force (or the exogenous shock process) and the transmission mechanism --- both crucial for the success of the model. The transmission mechanism (which involves strategic complementarities, low degree of substitutability between domestic and foreign goods, and home bias) is tightly disciplined by the micro-level empirical estimates in the international macroeconomics literature. The driving force are the exogenous small persistent shocks to international asset demand, which result in a wedge in the Euler equation for international bonds. We prove formally that this is the only shock that can generate exchange rate disconnect. We show the exchange rate disconnect in the context of a flexible price model with representative firms. The addition of heterogeneous firms and sticky prices improves the quantitative performance of the model, but does not affect its qualitative properties. Importantly, sticky prices are not necessary to generate exchange rate disconnect, as the driving force does not rely on the monetary shocks.