Intermediary-Determined Exchange Rates

This paper focused on the exchange rate disconnect puzzle in a two-country DSGE framework that features a financial intermediation sector. An intermediary is subject to two types of financing constraints: 1. a segmented deposit market restricted to local households, and 2. a balance-sheet constraint. These two constraints drive a wedge between marginal decisions of home and foreign intermediaries, which in turn, break the link between exchange rates and consumption differences in the Backus-Smith relationship. In contrast to traditional models which find a tight link between exchange rate growth and the consumption growth rate differential, the calibrated model produced a correlation of around -0.25, reconciling the model with the empirical evidence.