Pablo Cuba, FED Board

Paper: Exchange Rate Disconnect and the Trade Balance

Abstract: Unlike mechanisms of exchange rate determination that imply a stark dichotomy between the exchange rate and macroeconomic behavior, we offer a theory that naturally reunites macroeconomic fluctuations and the exchange rate through movements in the trade balance while being consistent with standard metrics of the exchange rate disconnect. We introduce time-varying preferences for domestic goods into an open economy model of exchange rate determination. These preferences induce trade rebalancing that shifts export demand towards domestic goods and reduces imports of foreign goods. We derive theoretical and quantitative implications of trade rebalancing as a candidate mechanism to explain several exchange rate puzzles observed in the data. The role of exogenous UIP deviations is substantially reduced in the presence of trade rebalancing.