Long Swings In The Exchange Rate And The Excess Returns Puzzle: The Ro

Long Swings in the Exchange Rate and the Excess Returns Puzzle: The Role of Imperfect Knowledge

The paper is a clear breath of "dirty" air in the sterile world of perfect

foresight. The authors offer a well worked out model of how agents persistently

bid the exchange rate away from the expected long-run equilibrium rate. It

seems intuitively comfortable to see the mathematical justification for the

unexplained excess returns to be a function of the distance from the bench-mark

(PPP). The uncertainty of a switch occurring in a regime (the Peso Problem) is

an interest-ing form within which to embed the imperfect information. It is a

format that seems ready to ex-pand into many other areas of economic modeling in

which expectations are at the core of the model's dynamics.

Of course, the choice of the benchmark is key to the mechanics of the process.

In this case, PPP is an obvious choice… but, since the idea of PPP drives this

model so strongly, it is interesting to look at its place and its

characteristics. In the paper, the authors note that if PPP holds, "relative

excess demand for domestic and foreign goods is zero." The obvious suggestion,

based on the model, is that the flow of goods and services is the foundation for

the equilibrating dynamic. Behind the flow of goods and services is the gap

between the gap between, domestic and foreign short-term rates, and the steady

state long-run interest rate gap that sets goods flows to zero. The assumption

is that the prices of the domestic and foreign goods in their respective for-

eign currencies are "incorrect" based on the fundamentals of the respective

countries and that agents know this (and know that the exchange rate path is

unstable) but cannot be sure of the de-gree of "incorrectness" or the

persistence of the di vergence. Embedded into this model are as-sumptions about

PPP that provide comfort about this benchmark's ability to give the "correct"

relative prices. It is possible that these assumptions, to some degree, mask

the complexity of the situation with respect to PPP's ability to proxy relative

prices. At the theoretical level, PPP should simply offer equal purchasing

power for equal commodity bundles through the exchange rate. Unfortunately, the

problem of explaining stylized facts requires some matching with reality. Set-

tling for getting the signs right mitigates much of the angst, but, as has been