turns Puzzle: The Role ofImperfect KnowledgeLong Swings in the Exchange Rate and the Excess Returns Puzzle: The Role ofImperfect KnowledgeWilliam StraussThe paper is a clear breath of “dirty” air in the sterile world of perfectforesight. The authors offer a well worked out model of how agents persistentlybid the exchange rate away from the expected long-run equilibrium rate. Itseems intuitively comfortable to see the mathematical justification for theunexplained 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) isan interest-ing form within which to embed the imperfect information. It is aformat that seems ready to ex-pand into many other areas of economic modeling inwhich 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 thismodel so strongly, it is interesting to look at its place and itscharacteristics. In the paper, the authors note that if PPP holds, “relativeexcess 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 forthe equilibrating dynamic. Behind the flow of goods and services is the gapbetween the gap between, domestic and foreign short-term rates, and the steadystate long-run interest rate gap that sets goods flows to zero. The assumptionis that the prices of the domestic and foreign goods in their respective for-eign currencies are “incorrect” based on the fundamentals of the respectivecountries and that agents know this (and know that the exchange rate path isunstable) but cannot be sure of the de-gree of “incorrectness” or thepersistence of the di vergence.
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Embedded into this model are as-sumptions aboutPPP that provide comfort about this benchmark’s ability to give the “correct”relative prices. It is possible that these assumptions, to some degree, maskthe complexity of the situation with respect to PPP’s ability to proxy relativeprices. At the theoretical level, PPP should simply offer equal purchasingpower for equal commodity bundles through the exchange rate. Unfortunately, theproblem of explaining stylized facts requires some matching with reality. Set-tling for getting the signs right mitigates much of the angst, but, as has beendemonstrated by the predictive abilities of many of the models to date, theproblem is not really solved.
Perhaps the model of PPP as a function ofinterest rates only misses somethingBut here we have a BIG step (from the real exchange rate side, not from the sideof better modeling PPP) toward not only getting the signs right, but alsounderstanding the dynamics of the switch. If PPP were built from a micro-foundation choice-based model (where demand-side ef-fects influencesaving/investment and interest rates), I suspect that we might see a realconver-gence toward understanding the excess returns puzzle.Business