Mussa Puzzle Redux

The Mussa (1986) puzzle is the empirical observation of a sharp, simultaneous increase in the volatility of both nominal and real exchange rates following the end of the Bretton Woods fixed exchange rate system in 1973 — a fact commonly interpreted as evidence for monetary non-neutrality. This paper resolves the puzzle by developing a model in which the dominant driver of nominal exchange rate fluctuations is a “financial shock” — a shock to the international demand for a country’s assets that is orthogonal to goods market fundamentals. Under a fixed rate, the central bank offsets financial shocks through reserve intervention, preventing them from moving the exchange rate; under a float, financial shocks freely move the nominal and real exchange rate simultaneously. The same framework also reconciles the Meese-Rogoff disconnect (exchange rates are unpredictable from macro fundamentals), the Backus-Smith puzzle, and the forward premium puzzle within a single unified model, with the financial shock accounting for the dominant share of exchange rate variance in each case.

Sanctions and the Exchange Rate

Itskhoki and Mukhin develop a tractable open-economy model with financial market segmentation — in which only the government sector (including state banks and exporting firms) can intermediate cross-border capital flows — to study how trade and financial sanctions affect the nominal exchange rate. Their first main result is a Lerner-symmetry equivalence: sanctions limiting a country’s exports or freezing its foreign assets depreciate the exchange rate, while sanctions limiting imports appreciate it, even though both types of policies have exactly the same effect on real allocations, including household welfare and government fiscal revenues. The mechanism is direct — export sanctions reduce the supply of foreign currency, requiring depreciation to restore market clearing, whereas import sanctions reduce the demand for foreign currency, requiring appreciation — and because real income effects are identical, the exchange rate movement is not informative about effectiveness: one cannot evaluate the effectiveness of sanctions based solely on the dynamics of the exchange rate. Beyond direct trade sanctions, increased precautionary savings in foreign currency also depreciate the exchange rate when they are not offset by the sale of official reserves or financial repression of foreign-currency savings. Applying the calibrated model to Russia’s post-invasion experience, the dynamics of the ruble exchange rate following Russia’s invasion of Ukraine in February 2022 are quantitatively consistent with the combined effects of these forces calibrated to the observed sanctions and government policies; the combined effect from 2.5 years of sanctions corresponds to a permanent decline in consumption of 0.9% in Russia, while the net effect is close to zero for the rest of the world, and the freeze of FX reserves together with import tariffs act as a positive transfer from Russia to the rest of the world while quantity restrictions on exports raise world energy prices and generate global welfare losses.

Dmitry Mukhin | Macro Paper Warehouse

Mussa Puzzle Redux

Sanctions and the Exchange Rate