CEPII, Recherche et Expertise sur l'economie mondiale
Wednesday May 17, 2017
15:00 - 16:00 - Salle Delors - CEPII, 113 rue de Grenelle, 75007 Paris
Exchange Rate Disconnect in General Equilibrium

Speaker: Oleg Itskhoki Associate Professor
Princeton University

Anne-Laure Delatte
Deputy Director of the CEPII
The presentation by Oleg Itskhoki (Princeton University) will provide an overview of a dynamic 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 puzzle, the PPP puzzle, the terms-of-trade puzzle, the Backus-Smith puzzle, and the UIP puzzle. The model has two main building blocks — the driving force (or the exogenous shock process) and the transmission mechanism — both crucial for the quantitative success of the model. The transmission mechanism — which relies on strategic complementarities in price setting, low degree of substitutability between domestic and foreign goods, and home bias in consumption — is tightly disciplined by the micro-level empirical estimates in the recent international macroeconomics literature. The driving force is an exogenous small but persistent shock to international asset demand, which result in a wedge in the Euler equation for international bonds.

The presentation will prove formally that this is the only shock that can generate exchange rate disconnect in the autarky limit. Oleg Itskhoki will demonstrate that a model with this financial shock alone is quantitatively consistent with the moments describing the dynamic comovement between exchange rates and the macro variables. The addition of heterogeneous firms and sticky wages and 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.