Exchange Rate Disconnect and the Trade Balance

Martin Bodenstein, Pablo Cuba-Borda, Nils Gornemann and Ignacio Presno
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Ignacio Presno: https://www.federalreserve.gov/econres/ignacio-presno.htm

No 1391, International Finance Discussion Papers from Board of Governors of the Federal Reserve System (U.S.)

Abstract: We propose a model with costly international financial intermediation that links exchange rate movements to shifts in the demand for domestically produced goods relative to the demand for imported goods (trade rebalancing). Our model is consistent with stylized facts of exchange rate dynamics, including those related to the trade balance, which is typically overlooked in the literature on exchange rate determination. In a quantitative assessment, trade rebalancing explains nearly 50 percent of exchange rate fluctuations over the business cycle, whereas exogenous deviations from the uncovered interest rate parity—the primary source of exchange rate fluctuations in the literature—account for just above 20 percent. Using data on trade flows or the trade balance is key to properly identifying the determinants of the exchange rate. Thus, our model overcomes the sharp dichotomy between the real exchange rate and the macroeconomy embedded in other models of exchange rate determination.

Keywords: Exchange Rates; Risk Sharing; Financial Intermediation; Trade Balance (search for similar items in EconPapers)
JEL-codes: F31 F32 F41 (search for similar items in EconPapers)
Date: 2024-07-11
New Economics Papers: this item is included in nep-fdg, nep-int and nep-opm
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedgif:1391

DOI: 10.17016/IFDP.2024.1391

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