“Noise Traders, Exchange Rate Disconnect Puzzle and Tobin Tax” by Juanyi XU
Simon Fraser University
This paper proposes a framework to explain why the nominal and real exchange rates are highly volatile and seem to be disconnected from the macroeconomic fundamentals. Two types of foreign exchange traders, rational traders and noise traders with erroneous stochastic beliefs, are introduced into the dynamic general equilibrium framework of the new open economy macroeconomic literature. The presence of noise traders creates deviations from the uncovered interest parity. As a result, exchange rates can diverge significantly from the fundamental values. Combined with local currency pricing and consumption smoothing behavior in an infinite horizon model, the presence of noise traders can help to explain the “exchange rate disconnect puzzle". Then we show that the excess exchange rate volatility caused by the presence of noise traders can be reduced by the "Tobin tax" type of exchange rate policies.