Viewpoint: Towards a solution to the puzzles in exchange rate economics: where do we stand?

TLDR

This paper provides a selective overview of puzzles in exchange rate economics. The authors review three key exchange‑rate puzzles—the forward bias, purchasing‑power‑parity, and exchange‑rate disconnect—by critically examining the literature and proposing potential solutions. The review highlights unresolved issues and suggests possible resolutions for each puzzle. Abstract; JEL classification: F31.

Abstract

Abstract. 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 analyse 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. JEL classification: F31