Discussion Paper No. 977

A POSSIBLE EXPLANATION
OF THE ‘EXCHANGE RATEDISCONNECT PUZZLE’:
A COMMON SOLUTION TO THREE
MAJOR MACROECONOMIC PUZZLES?

Charles Yuji Horioka
Nicholas Ford

July 2016

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, JapanA Possible Explanation of the ‘Exchange Rate Disconnect Puzzle’: A Common Solution to Three
Major Macroeconomic Puzzles?
Charles Yuji Horioka
Asian Growth Research Institute; Institute of Social and Economic Research, Osaka University; andNational Bureau of Economic Research
Nicholas Ford
Wolfson College, Cambridge University
July 13, 2016
Abstract
Meese and Rogoff (1983) and subsequent studies find that economic fundamentals are apparently
not able to explain exchange rate movements, but we argue that this so‐called “Exchange Rate
Disconnect Puzzle” arose because researchers such as Meese and Rogoff (1983) did not use the rightfundamentals and because they did not allow for the forward‐looking nature of exchange rate
determination. Further, because they apparently were not aware that financial markets bythemselves could not equalise interest rates across countries, they did not properly appreciate thatthe exchange rate is strongly influenced by agents’ expectations of aggregated differences in local
returns. Thus, we believe that the same underlying explanation provided by Ford (2015) and Ford andHorioka (2016a and 2016b) for the Feldstein‐Horioka (1980) Puzzle and the PPP Puzzle‐‐namely that
financial markets alone cannot achieve net transfers of financial capital and cannot equalise realinterest rates across countries‐‐also helps explain why previous attempts to connect changes in theexchange rate to economic fundamentals have not been successful, and so can also be said tocontribute to solving the Exchange Rate Disconnect Puzzle.
JEL classification codes: F21, F31, F32, F36, G15
Key words: Exchange Rate Disconnect Puzzle, exchange rate determination, exchange rate volatility,
Feldstein‐Horioka puzzle or paradox, financial market integration, goods market integration,international capital flows, international capital mobility, net transfers of capital, PPP puzzle,
purchasing power parity puzzle, real interest rate equalisation, real interest rate parity*The authors are indebted to Neil Gorman and Gerry Mulligan for their valuable advice and comments.
This work was supported by JSPS (Japan Society for the Promotion of Science) KAKENHI Grant Number
15H01950, an Asian Growth Research Institute project grant, and a grant from the MEXT Joint
Usage/Research Center at the Institute of Social and Economic Research, Osaka University. Anyremaining errors are the authors’.
**Corresponding author: Charles Yuji Horioka, Asian Growth Research Institute, 11‐4, Ohtemachi,
Kokurakita‐ku, Kitakyushu, Fukuoka 803‐0814, Japan. Telephone: 81‐93‐583‐6202. Facsimile: 81‐93‐
583‐6576. E‐mail address: horioka@iser.osaka‐u.ac.jp

1. Introduction
In the early 1970s, the Bretton Woods fixed exchange rate system broke down. Most major currencies
were allowed to freely float, and exchange controls were lifted in many countries. As banks and otherinstitutions began trading foreign assets, the volume of foreign exchange transactions for thepurchase of such assets increased many fold, far exceeding that for the purposes of trade. The
volatility of nominal and real exchange rates increased significantly, and some countries developed
either persistent trade deficits or trade surpluses.
Researchers were pushed to the conclusion that, in the new circumstances involving floating exchange
rates and agents being free to purchase foreign assets, the exchange rate was determined by agents’relative valuations of domestic and foreign assets, rather than being determined by the terms of tradeand comparative advantage. Various ‘asset market macro‐models’ were put forward to try to capture
these effects, such as those of Dornbusch (1976) and Branson (1980).
At their time of publication, there was optimism that such models could explain actual exchange rate
movements and exchange rate volatility. However, econometric testing could not connect changes inthe explanatory variables of these models (such as stocks of money and differences in short‐terminterest rates) to actual exchange rate movements (see, for example, Meese and Rogoff, 1983). This
lack of apparent connection of the exchange rate to ‘economic fundamentals’ was labelled by somethe ‘Exchange Rate Disconnect Puzzle’ and was included by Obstfeld and Rogoff (2000) in their ‘Six
Major Puzzles in Macroeconomics’ (see, amongst others, Flood and Rose, 1995 and 1999, andMacDonald, 1999). Although some progress has been made in understanding some aspects of
exchange rate movements, this Exchange Rate Disconnect Puzzle cannot be said to have been fully
resolved.
Ford (2015) and Ford and Horioka (2016a and 2016b) put forward what they believe to be thesolutions to two of Obstfeld and Rogoff’s (2000) “Six Major Puzzles”‐‐the Feldstein‐Horioka (1980)
Puzzle and the Purchasing Power Parity (PPP) Puzzle‐‐using a number of hypothetical scenarios to help
clarify both the separate and combined effects of international goods markets and international
financial markets. In this paper, it is suggested that a similar approach might help resolve the Exchange
Rate Disconnect Puzzle.

2. Four Scenarios
Taylor and Taylor (2004) suggest that Rogoff’s ‘PPP Puzzle’ can usefully be regarded as two puzzles.
One concerns why ‘equilibrium’ exchange rates should deviate from PPP, and the second concerns
why actual real exchange rates also appear to deviate from these ‘equilibrium‘ rates but eventually
revert back to them. We attempt to build on this thinking by considering different markets’ effects
on the exchange rate.
We consider 4 hypothetical scenarios in which there are only 2 countries in the world, Japan and the
U.S. We assume that the return on real capital and the risk‐free interest rate are initially higher in the
U.S. than in Japan. In Scenarios 2, 3 and 4, the exchange rate is allowed to freely float.
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Scenario 1. In the first scenario, both international goods markets and asset markets are closed, andthe two countries are in an autarky condition. There is no market for foreign exchange so theexchange rate is indeterminate, and there are no forces causing interest rates in the two countries toconverge. Needless to say, if we ran Meese and Rogoff (1983)‐type regressions, none of the
explanatory variables would be significant as the exchange rate is indeterminate.
Scenario 2. In the second scenario, the purchase of foreign goods and services is permitted, but theacquisition of foreign assets is prohibited. Under these circumstances, trade must be balanced. Let
us suppose that both countries are able to produce manufactured goods, services, and natural
resource‐type commodities such as oil, coal and metal ores, but that the US has a very significant
comparative advantage in producing natural resource‐type commodities. We would expect that theresult of trade would be for Japan to be a net exporter of manufactured goods and to be a net importerof natural resource‐type commodities. However, there can be no net transfer of capital between thetwo countries, and thus no reason for interest rates in the two countries to converge.
The exchange rate would not necessarily be PPP for reasons that have been extensively researched.
We suggest that the currently accepted explanations for divergence from PPP in this scenario might
conveniently be grouped into two categories:
Firstly, if the Law of One Price held at all times for traded goods, the Balassa‐Samuelson effect(concerning relative productivities in tradeables and non‐tradeables) might result in the exchange rate
deviating from PPP.
Secondly, the exchange rate may deviate from PPP because the Law of One Price does not necessarily
hold (see, for example, Podkaminer (2013) and Taylor and Taylor (2004) for a survey of the relevant
literature). Obstfeld and Rogoff (2000) suggest that many of these explanations might ultimately besummarised as ‘trade costs’ or ‘frictions’ (which include, for example, the costs of transport, marketingand distribution costs, technical standards, certification procedures, tariffs, and non‐tariff barriers)(see also Lee and Shin, 2010). They argue that the division of goods into ‘tradeables’ and ‘non‐tradeables’ is in certain circumstances unhelpful and that it is better to consider that there is acontinuum of different goods that have progressively higher trade costs. Such an interpretation
implies, in this scenario, that the exchange rate must deviate from PPP until it renders a sufficientquantity of Japanese manufactured goods cheap enough when exported to compensate for the costsof transporting them to, and selling them in, US markets, and so provide the quantity of foreignexchange required to import natural resource‐type commodities. If the price of such commodities
relative to manufactured goods changes, then Japan would have to export a different quantity of
manufactured goods to pay for its imported commodities, and we would expect the real exchange
rate to change to ensure that trade remained balanced.
Let us refer to the hypothetical exchange rate in this scenario as the ‘balanced current accountexchange rate’ (BCAER). We suggest that the deviation of the BCAER from PPP in this scenario isloosely equivalent to Taylor and Taylor’s (2004) ‘first PPP Puzzle.’ This BCAER clearly must be related
to ‘fundamentals,’ these being commodity prices, ‘transport costs’ and relative productivities. As
these change, the BCAER will change. If we ran Meese and Rogoff (1983)‐type regressions on this2

exchange rate in these hypothetical circumstances, it would register no correlation with their‘fundamentals’ because the explanatory variables in that regression calculation (such as stocks ofmoney, short‐term interest rates, etc.) are obviously not significant determinants of the exchange ratein this scenario.
Scenario 3. In this scenario, the purchase of foreign goods and services is not allowed, but thepurchase of foreign financial assets is allowed for just 5 years, at the end of which foreign assets must
be sold back to the authorities at an exchange rate known to agents in advance and estimated by theauthorities to be PPP. As discussed in Ford (2015) and Ford and Horioka (2016a and 2016b), in suchcircumstances, purely financial transactions in international markets cannot result in a net transfer ofcapital (real or financial) between the countries. This is because a transfer of financial capital between
countries by any party is cancelled out by the transfer of financial capital in the reverse direction by
the counter party to the transaction. Further, such transactions cannot result in any change in the
return on real assets. Let us suppose there is no foreign country risk premium. Agents in Japan would
prefer to own higher yielding US assets than Japanese assets, and so will bid up the value of the US
dollar above PPP by an amount influenced by their expectations of the aggregated yield difference on
assets over the remainder of the period. Further, if we suppose that both the returns on risky andrisk‐free assets may change over the 5‐year period in both countries, we would expect the current
exchange rate to also change when expectations of aggregated future returns on assets change. We
suggest that the resultant deviations from PPP in this scenario correspond loosely to the explanationof Taylor and Taylor’s (2004) second PPP puzzle.
In this scenario, if we ran regressions similar to Meese and Rogoff (1983) but in real terms, we might
again expect to find little correlation with variables such as output and money stocks as these do notmuch affect aggregated real yield differences, but we might expect to find a correlation with short‐term real interest rates. However, even this is not clear cut. Because agents are forward‐looking, it ischanges in expectations of aggregated future interest rate differentials, not actual changes in current
interest rate differentials, that should be correlated with exchange rate movements. However, if how
far in advance agents anticipate changes in short‐term rates varies from episode to episode, this may
well confound conventional econometrics and deny a connection between exchange rates andinterest rates even though one actually exists. Obstfeld and Rogoff (2000) suggest that the apparent
disconnect between the exchange rate and economic fundamentals may be analogous to the apparent
lack of connection between stock prices and fundamentals. We concur with this in that stock prices
are affected by expectations of aggregated future company earnings, and changes in suchexpectations affect stock prices. If how far in advance agents anticipate changes in company earnings
varies from episode to episode, it may appear superficially that stock price movements are not closely
connected to earnings.
Scenario 4. In this scenario, both the purchase of foreign goods and services and foreign assets areallowed without limit. Now we would expect the exchange rate to be influenced simultaneously by
the factors present in Scenarios 2 and 3. However, the situation is even more complicated. When
agents bid up the value of the dollar above the BCAER, the US will incur a current account deficit andJapan a surplus. This imbalance represents a net transfer of real and financial capital from Japan to
the US, which has consequences. As discussed in Ford (2015) and Ford and Horioka (2016a and 2016b),3

over the long term, this trade deficit will affect stocks of real capital and tend to cause real interest
rates to converge. Further, the earnings of the accumulation of Japanese owned assets situated in
the US will affect the long‐run current account. Moreover, the effect on capital stocks is not the only
mechanism by which a trade imbalance can affect local interest rates. Rapid changes in net trade
positions will also have a transitory impact on aggregate demand, which in turn may have a transitory
effect on local short‐term interest rates.
For example, suppose markets receive news of improved prospects for economic growth in the US.
This increases the prospects for future interest rate rises, and so changes agents’ expectations of
aggregated future yield differences. This in turn causes forward‐looking agents to bid up the value ofthe dollar. However, this rise in the dollar has a contractionary effect on the US economy which itself
may push back the timing of the interest rate rise. As a consequence, conventional econometrics à laMeese and Rogoff (1983) may have even more difficulty in correlating exchange rate movements withactual interest rate movements in Scenario 4 than in Scenario 3.

3. Summary and Conclusion

Meese and Rogoff (1983) and subsequent studies find that the economic fundamentals they consider(such as output, stocks of money, stocks of bonds, and differences in short‐term interest rates) cannot
explain actual exchange rate movements. However, we show using our four scenarios approach that
economic fundamentals do explain deviations of the BCAER from PPP but that the relevant
fundamentals are the terms of trade (exemplified by commodity prices), transport costs, and theBalassa‐Samuelson effect, not the ones considered by Meese and Rogoff (1983). It is thesefundamentals as well as the accumulation of foreign‐owned assets that drive the underlying BCAER,
and it is changes in expectations of aggregated future differences in the returns on real and financial
assets (driven by news or fresh analysis) that drive deviations of the actual exchange rate from this
BCAER. We maintain that the exchange rate appears to be disconnected from economic fundamentals
to researchers such as Meese and Rogoff (1983) because they did not use the right fundamentals andbecause they did not allow for the forward‐looking nature of exchange rate determination. Further,because they were apparently not aware that financial markets by themselves could not equalise realinterest rates across countries, they did not properly appreciate that the exchange rate is strongly
influenced by agents’ expectations of aggregated differences in local real returns; this also applies to
Obstfeld and Rogoff (2000).
Thus, we believe that the same underlying explanation provided by Ford (2015) and Ford and Horioka(2016a and 2016b) for the Feldstein‐Horioka (1980) Puzzle and the PPP Puzzle‐‐namely that financial
markets alone cannot achieve net transfers of financial capital and cannot equalise real interest rates
across countries‐‐also helps explain why previous attempts to connect changes in the exchange rate
to economic fundamentals have not been successful, and so can also be said to contribute to solving
the Exchange Rate Disconnect Puzzle.

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