What Drives the Exchange Rate?

Oleg Itskhoki and Dmitry Mukhin

No 32008, NBER Working Papers from National Bureau of Economic Research, Inc

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 macroeconomic 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 macroeconomic 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.

JEL-codes: F31 F41 F44 (search for similar items in EconPapers)
Date: 2023-12
New Economics Papers: this item is included in nep-fdg, nep-ifn, nep-mon and nep-opm
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