Mussa Puzzle Redux
What this paper finds — and why it matters
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.
Summary of a forthcoming paper, AI-assisted and human-reviewed. See the linked original for the authoritative claims and full conditions.
Q1. What is the financial shock and how does it differ from standard macro shocks?
The financial shock is an orthogonal disturbance to international portfolio demand — the preference of foreign investors for holding domestic versus foreign assets — that is disconnected from productivity, monetary policy, and goods-market conditions. Because it is uncorrelated with macro fundamentals, it generates exchange rate movements without corresponding movements in output, prices, or interest rate differentials, producing the observed disconnect between exchange rates and macro variables.
Q2. Why does the Mussa pattern arise from regime switching?
Under a fixed rate, the central bank absorbs financial shocks via reserve intervention, sterilizing their exchange rate effects; the real exchange rate is equally insulated because the nominal rate is fixed and prices adjust slowly. Under a float, the same financial shocks freely move the nominal exchange rate, and with sticky prices this passes through to the real exchange rate. The variance of the real exchange rate therefore jumps discontinuously at the regime switch, matching the sharp Mussa empirical finding without requiring any change in the shock process.
Q3. How unified is the resolution across exchange rate puzzles?
A single model with the financial shock, sticky prices, and a standard asset pricing kernel simultaneously matches the Mussa pattern (regime-switching real volatility), the Meese-Rogoff disconnect (exchange rates unpredictable from fundamentals), the Backus-Smith puzzle (exchange rates and relative consumption uncorrelated), and the forward premium puzzle (high-interest-rate currencies appreciate). The financial shock accounts for the majority of exchange rate variance in each application.
Key concepts
Mussa puzzle : the discrete jump in real exchange rate volatility at the Bretton Woods breakdown (1973); resolved in this paper as the change in the central bank’s absorption of financial shocks between fixed and floating regimes.
financial shock : a disturbance to international portfolio demand orthogonal to goods-market fundamentals; the paper’s key mechanism for exchange rate disconnect, the Mussa pattern, and several other exchange rate puzzles.