Post by ehsanulh125 on Jan 9, 2024 1:09:22 GMT -6
In economics, we call those empirical phenomena that we cannot explain with the help of previous theories a puzzle. It is important to emphasize that it is not a question of a phenomenon contradicting any theory that came out of thin air, but rather that the empirical results contradict theories that have already been proven during the examination of other similar phenomena. When examining currency exchange rates, we can come across quite a few of these mysteries. Let's review them briefly. The Meese-Rogoff (1983) puzzle concerns the empirical behavior of nominal exchange rates. We would expect currency rates to behave like other financial asset prices, their behavior can be well explained by certain fundamentals.
In contrast, nominal Country Email List exchange rates correlate very weakly with possible macroeconomic fundamentals, are typically much more volatile than them, and their behavior can mostly be described as a random walk. The purchasing power parity puzzle (PPP) is summarized in Rogoff's (1996) article. Due to the competition in the goods market, we would think that the prices of the same goods in two different countries expressed in the same currency are very similar, their ratio is relatively constant. On an aggregate level, this results in the fact that the ratio of the price level of the two countries, i.e. the real exchange rate, does not fluctuate much when expressed in the same currency; movements of the nominal exchange rate are reflected in the different inflation rates of the two countries.
However, the facts radically contradict this: the movements of the nominal exchange rate are closely followed by the movements of the real exchange rate, which, like the nominal exchange rate, is volatile and persistent, approaching random wandering. The Backus - Smith (1993) puzzle starts from the fact that international trade is suitable for optimally sharing the risks arising from individual shocks to different countries between countries. In the case of optimal risk sharing, the relative consumption of the countries would move together with the real exchange rate, that is, the consumption of the country whose real exchange rate depreciates would grow relatively more. However, the facts contradict this: relative consumption is very weakly correlated with the real exchange rate, and the sign of the empirical correlation is the exact opposite of what the theory implies.
In contrast, nominal Country Email List exchange rates correlate very weakly with possible macroeconomic fundamentals, are typically much more volatile than them, and their behavior can mostly be described as a random walk. The purchasing power parity puzzle (PPP) is summarized in Rogoff's (1996) article. Due to the competition in the goods market, we would think that the prices of the same goods in two different countries expressed in the same currency are very similar, their ratio is relatively constant. On an aggregate level, this results in the fact that the ratio of the price level of the two countries, i.e. the real exchange rate, does not fluctuate much when expressed in the same currency; movements of the nominal exchange rate are reflected in the different inflation rates of the two countries.
However, the facts radically contradict this: the movements of the nominal exchange rate are closely followed by the movements of the real exchange rate, which, like the nominal exchange rate, is volatile and persistent, approaching random wandering. The Backus - Smith (1993) puzzle starts from the fact that international trade is suitable for optimally sharing the risks arising from individual shocks to different countries between countries. In the case of optimal risk sharing, the relative consumption of the countries would move together with the real exchange rate, that is, the consumption of the country whose real exchange rate depreciates would grow relatively more. However, the facts contradict this: relative consumption is very weakly correlated with the real exchange rate, and the sign of the empirical correlation is the exact opposite of what the theory implies.
