Towards a Solution to the Puzzles in Exchange Rate Economics: Where Do We Stand?

This paper provides a selective overview of puzzles in exchange rate economics. We begin with the forward bias puzzle: high interest rate currencies appreciate when one might guess that investors would demand higher interest rates on currencies expected to fall in value. We then analyze the purchasing power parity puzzle: the real exchange rate displays no (strong) reversion to a stable long-run equilibrium level. Finally, we cover the exchange rate disconnect puzzle: the lack of a link between the nominal exchange rate and economic fundamentals. For each puzzle, we critically review the literature and speculate on potential solutions.

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