Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?

Empirical evidence shows that macroeconomic fundamentals have little explanatory power for nominal exchange rates. On the other hand, the recent microstructure approach to exchange rates' has shown that most exchange rate volatility at short to medium horizons is related to order flows. This suggests that investor heterogeneity might be key to understanding exchange rate dynamics, in contrast to the common representative agent approach in macroeconomic models of exchange rate determination. To explore this issue, we introduce investor heterogeneity into an otherwise standard monetary model of exchange rate determination. There are two types of heterogeneity: dispersed information about fundamentals and non-fundamentals based heterogeneity (e.g., liquidity traders). We show that information dispersion leads to magnification and endogenous persistence of the impact of non-fundamentals trade on the exchange rate rational confusion about the source of exchange rate fluctuations. Higher order expectations, familiar from Keynes' beauty contest', partly contribute to these results. The implications of the model are consistent with the evidence on the relationship between exchange rates and fundamentals: (i)fundamentals play little role in explaining exchange rate movements in the short to medium run, (ii) over longer horizons the exchange rate is primarily driven by fundamentals, (iii) exchange rate changes are a weak predictor of future fundamentals.

Rational Inattention: A Solution to the Forward Discount Puzzle

The uncovered interest rate parity equation is the cornerstone of most models in international macro. However, this equation does not hold empirically since the forward discount, or interest rate differential, is negatively related to the subsequent change in the exchange rate. This forward discount puzzle is one of the most extensively researched areas in international finance. It implies that excess returns on foreign currency investments are predictable. In this paper we propose a new explanation for this puzzle based on rational inattention. We develop a model where investors face a cost of collecting and processing information. Investors with low information processing costs trade actively, while other investors are inattentive and trade infrequently. We calibrate the model to the data and show that (i) inattention can account for most of the observed predictability of excess returns in the foreign exchange market, (ii) the benefit from frequent trading is relatively small so that few investors choose to be attentive, (iii) average expectational errors about future exchange rates are predictable in a way consistent with survey data for market participants, and (iv) the model can account for the puzzle of delayed overshooting of the exchange rate in response to interest rate shocks.forward discount puzzle; excess return predictability; rational

Higher Order Expectations in Asset Pricing

In this paper, we examine formally Keynes' idea that higher order beliefs can drive a wedge between an asset price and its fundamental value based on expected future payoffs. In a dynamic noisy rational expectations model, higher order expectations add an additional term, which we call the higher order wedge, to a standard asset pricing equation. Consistent with Keynes' reasoning we show that investment decisions are based not just on expected future payoffs, but also on anticipated future expectational errors made by the market. The latter are captured by the higher order wedge. We show that the expectation of future expectational errors by the market is perfectly rational when investors have both noisy public and private information. The main effect of this additional asset pricing term is to disconnect the price from the present value of future payoffs. We show that this effect can be quantitatively signiffcant.

A Theory of the Currency Denomination of International Trade

Nominal rigidities due to menu costs have become a standard element in closed economy macroeconomic modelling. The 'New Open Economy Macroeconomics' literature has investigated the implications of nominal rigidities in an open economy context and found that the currency in which prices are set has significant implications for exchange rate pass-through to import prices, the level of trade and net capital flows, and optimal monetary and exchange rate policy. While the literature has exogenously assumed in which currencies goods are priced, in this paper we solve for the equilibrium optimal pricing strategies of firms. We find that the higher the market share of an exporting country in an industry, and the more differentiated its goods, the more likely its exporters will price in the exporter's currency. Country size and the cyclicality of real wages play a role as well, but are empirically less important. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.currency invoicing; new open economy macroeconomics

A Theory of the Currency Denomination of International Trade

Nominal rigidities due to menu costs have become a standard element in closed economy macroeconomic modeling. The 'New Open Economy Macroeconomics' literature has investigated the implications of nominal rigidities in an open economy context and found that the currency in which prices are set has significant implications for exchange rate pass-through to import prices, the level of trade and net capital flows, and optimal monetary and exchange rate policy. While the literature has exogenously assumed in which currencies goods are priced, in this paper we solve for the equilibrium optimal pricing strategies of firms. We find that the higher the market share of an exporting country in an industry, and the more differentiated its goods, the more likely its exporters will price in the exporter's currency. Country size and the cyclicality of real wages play a role as well, but are empirically less important. We also show that when a set of countries forms a monetary union, the new currency is likely to be used more extensively in trade than the sum of the currencies it replaces.

A Scapegoat Model of Exchange Rate Fluctuations

While empirical evidence finds only a weak relationship between nominal exchange rates and macroeconomic fundamentals, forex markets participants often attribute exchange rate movements to a macroeconomic variable. The variables that matter, however, appear to change over time and some variable is typically taken as a scapegoat. For example, the current dollar weakness appears to be caused almost exclusively by the large current account decit, while its previous strength was explained mainly by growth differentials. In this paper, we propose an explanation of this phenomenon in a simple monetary model of the exchange rate with noisy rational expectations, where investors have heterogeneous information on some structural parameter of the economy. In this context, there may be rational confusion about the true source of exchange rate fluctuations, so that if an unobservable variable aects the exchange rate, investors may attribute this movement to some current macroeconomic fundamental. We show that this effect applies only to variables with large imbalances. The model thus implies that the impact of macroeconomic variables on the exchange rate changes over time.

Why Do Consumer Prices React less than Import Prices to Exchange Rates?

It is well known that the extent of pass-through of exchange rate changes to consumer prices is much lower than to import prices. One explanation is local distribution costs. Here we consider an alternative, complementary, explanation based on the optimal pricing strategies of firms. We consider a model where foreign exporting firms sell intermediate goods to domestic firms. Domestic firms assemble the imported intermediate goods and sell final goods to consumers. When domestic firms face significant competition from other domestic final goods producing sectors (e.g., the non-traded goods sector) we show that they prefer to price in domestic currency, while exporting firms tend to price in the exporter's currency. In that case the pass-through to import prices is complete, while the pass-through to consumer prices is zero.

A Scapegoat Model of Exchange Rate Fluctuations

While empirical evidence finds only a weak relationship between nominal exchange rates and macroeconomic fundamentals, forex markets participants often attribute exchange rate movements to a macroeconomic variable. The variables that matter, however, appear to change over time and some variable is typically taken as a scapegoat. For example, the current dollar weakness appears to be caused almost exclusively by the large current account deficit, while its previous strength was explained mainly by growth differentials. In this paper, we propose an explanation of this phenomenon in a simple monetary model of the exchange rate with noisy rational expectations, where investors have heterogeneous information on some structural parameter of the economy. In this context, there may be rational confusion about the true source of exchange rate fluctuations, so that if an unobservable variable affects the exchange rate, investors may attribute this movement to some current macroeconomic fundamental. We show that this effect applies only to variables with large imbalances. The model thus implies that the impact of macroeconomic variables on the exchange rate changes over time.heterogeneous information; model uncertainty

Is Home Bias in Assets Related to Home Bias in Goods?

Obstfeld and Rogoff (2000) have reinvigorated an old literature on the link between home bias in the goods market and home bias in the asset market by arguing that trade costs in the goods market can account for the observed portfolio home bias. The key link between home bias in the two markets is the real exchange rate. Home bias in consumption implies a different expenditure allocation across countries, which leads to different inflation rates when measured in the same currency. This leads investors from different countries to choose different portfolios to hedge against inflation uncertainty. An older partial equilibrium literature argued that such hedge portfolios are not large enough to produce substantial home bias. We link the general equilibrium and partial equilibrium literatures and show that in both the resulting home bias in the equity market depends on a covariance-variance ratio: the covariance between the real exchange rate and the excess return on home relative to foreign equity, divided by the variance of the excess return. Empirical evidence shows that this ratio and the implied home bias are close to zero, casting significant doubt on a meaningful link between home bias in the goods and asset markets. General equilibrium models that conclude otherwise imply a covariance-variance ratio that is at odds with the data.

Tacit On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals

It is well known from anecdotal, survey and econometric evidence that the relationship between the exchange rate and macro fundamentals is highly unstable. This could be explained when structural parameters are known and very volatile, neither of which seems plausible. Instead we argue that large and frequent variations in the relationship between the exchange rate and macro fundamentals naturally develop when structural parameters in the economy are unknown and change very slowly. We show that the reduced form relationship between exchange rates and fundamentals is driven not by the structural parameters themselves, but rather by expectations of these parameters. These expectations can be highly unstable as a result of perfectly rational "scapegoat" effects. This happens when parameters can potentially change much more in the long run than the short run. This generates substantial uncertainty about the level of parameters, even though monthly or annual changes are small. This mechanism can also be relevant in other contexts of forward looking variables and could explain the widespread evidence of parameter instability found in macroeconomic and financial data. Finally, we show that parameter instability has remarkably little effect on the volatility of exchange rates, the in-sample explanatory power of macro fundamentals and the ability to forecast out of sample.exchange rate; time-varying coefficients