Monday , November 11 2019
Home / Bank of International Settlement / Exchange rate puzzles: evidence from rigidly fixed nominal exchange rate systems

Exchange rate puzzles: evidence from rigidly fixed nominal exchange rate systems

Summary:
BIS Working Papers  |  No 805  |  09 August 2019 by  Charles Engel and Feng Zhu PDF full text (841kb)  |  49 pages Focus This paper focuses on six major exchange rate puzzles identified by the literature: the excess volatility of real exchange rates; their excess reaction to the real interest rate differentials; the uncovered interest rate parity (UIP) puzzle; the excess persistence of real exchange rates; the exchange rate disconnect puzzle; and the consumption correlation puzzle. We examine the behaviour of real exchange rates among pairs of economies that have rigidly fixed nominal

Topics:
International Settlement considers the following as important:

This could be interesting, too:

Swiss National Bank writes 2019-11-11 – Important monetary policy data for the week ending 8 November 2019

Bank of Japan writes Summary of Opinions at the Monetary Policy Meeting on October 30 and 31, 2019

Bank of Japan writes Principal Figures of Financial Institutions (Oct.)

Cash writes Avenir Suisse erteilt Schweizer Staatsfonds klare Absage

BIS Working Papers  |  No 805  | 
09 August 2019
PDF full text
 (841kb)
 |  49 pages

Focus

This paper focuses on six major exchange rate puzzles identified by the literature: the excess volatility of real exchange rates; their excess reaction to the real interest rate differentials; the uncovered interest rate parity (UIP) puzzle; the excess persistence of real exchange rates; the exchange rate disconnect puzzle; and the consumption correlation puzzle. We examine the behaviour of real exchange rates among pairs of economies that have rigidly fixed nominal exchange rates, compared with that among economies with floating exchange rates. Our purpose is to see which of the puzzles, if any, are significantly different under rigidly fixed exchange rates versus floating exchange rates.

Contribution

Differently from previous work, we compare the degree to which the puzzles hold among pairs of economies with floating exchange rates (eg among the pairs of OECD member countries that are not in the euro area) with pairs of economies that have rigidly fixed exchange rates (such as Hong Kong SAR versus the United States and country pairs within the euro area). We also extend the analysis to intra-national data, such as for US states and Canadian and Chinese provinces, and examine at least some of these propositions, depending on data availability. Within national borders, nominal exchange rates are irrevocably fixed, providing the best possible example of fixed exchange rates. The evidence from our analysis may provide clues to the types of model that are useful for resolving the puzzles - and therefore, the types of model that are most useful for open-economy macroeconomic analysis.

Findings

Our results suggest that, for those economies with a rigidly fixed nominal exchange rate arrangement, the excess volatility puzzle of real exchange rates practically disappears or becomes minor for the vast majority of the fixed rate economies; there is less evidence for an excess reaction of the real exchange rate to the real interest rate differential; there is less disconnect between the real exchange rate and the economic fundamentals; and the uncovered interest rate parity appears to hold more frequently in these economies. However, real exchange rates are as persistent in these economies as in the floating-rate economies, and the evidence on risk-sharing shows little difference among countries with fixed versus floating nominal exchange rates.


Abstract

We examine several major exchange rate puzzles: the excess volatility of real exchange rates; their excess reaction to the real interest rate differentials; the uncovered interest rate parity (UIP) puzzle; the excess persistence of real exchange rates; the exchange rate disconnect puzzle; and the consumption correlation puzzle. We examine the behaviour of real exchange rates among pairs of economies that have rigidly fixed nominal exchange rates, eg countries within the euro area, regions in China and Canada, and Hong Kong SAR vis-à-vis the United States, compared with that among non-euro-area OECD economies.

Our results suggest that some of these puzzles are less puzzling under a rigidly fixed exchange rate regime. In particular, real exchange rates appear to have no or little excess volatility; excess reaction of the real exchange rate to real interest rates is less common; there is less disconnect between the real exchange rate and the economic fundamentals; and uncovered interest rate parity appears to hold more frequently in these economies. However, real exchange rates are as persistent in these economies as in the floating rate economies and there appears to be little difference in risk-sharing across countries with fixed versus floating nominal exchange rates. These results may have implications for exchange rate modelling.

JEL codes: E43, F31

Keywords: consumption correlation puzzle, excess volatility, exchange rate disconnect, exchange rate regime, real exchange rate, purchasing power parity, uncovered interest rate parity

International Settlement
The Bank for International Settlements (BIS) is an international company limited by shares owned by central banks which "fosters international monetary and financial cooperation and serves as a bank for central banks". The BIS carries out its work through subcommittees, the secretariats it hosts and through an annual general meeting of all member banks. It also provides banking services, but only to central banks and other international organizations. It is based in Basel, Switzerland, with representative offices in Hong Kong and Mexico City.

Leave a Reply

Your email address will not be published. Required fields are marked *