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Three Exchange Rate Puzzles: Fact or Fiction?

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Book cover Exchange Rates and Macroeconomic Dynamics

Part of the book series: Applied Econometrics Association Series ((AEAS))

Abstract

In their provocative paper, Obstfeld and Rogoff (2000) advocated explaining six key puzzles in International Finance by appealing to transaction costs. Their paper has generated a large and vibrant literature which seeks to establish if indeed transaction costs explain the puzzles. In this paper we examine two of the puzzles addressed in Obstfeld and Rogoff, namely the PPP puzzle and the exchange rate disconnect. We argue that the latter actually has two puzzles subsumed within it, what we refer to as the levels and volatility puzzles. Hence, in total, we explore three puzzles in this paper. A common conclusion often expressed regarding the puzzles is that they cannot be understood in terms of a standard macroeconomic framework and therefore to understand exchange rate behaviour the profession has to move towards a market microstructure approach and effectively abandon macroeconomic fundamentals (see for example, Flood and Rose (1995)). The bottom line in this paper is, however, that macroeconomic fundamentals are useful for explaining exchange rate behaviour and indeed can be used to explain the exchange rate puzzles.

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Authors
  1. Ronald MacDonald
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Editors and Affiliations

  1. European Central Bank, Germany

    Pavlos Karadeloglou (Head of the Global Economy Section) (Head of the Global Economy Section)

  2. University of Luxembourg, Luxembourg

    Virginie Terraza (Assistant Professor) (Assistant Professor)

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© 2008 Applied Econometrics Association

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MacDonald, R. (2008). Three Exchange Rate Puzzles: Fact or Fiction?. In: Karadeloglou, P., Terraza, V. (eds) Exchange Rates and Macroeconomic Dynamics. Applied Econometrics Association Series. Palgrave Macmillan, London. https://doi.org/10.1057/9780230582699_2

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