Essay Database

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 …

…of interest rates only misses something... But here we have a BIG step (from the real exchange rate side, not from the side of better modeling PPP) toward not only getting the signs right, but also understanding the dynamics of the switch. If PPP were built from a micro-foundation choice-based model (where demand-side ef-fects influence saving/investment and interest rates), I suspect that we might see a real conver-gence toward understanding the excess returns puzzle.