This paper presents a comprehensive literature review of the theoretical and empirical developments that have taken place over the last two decades in an attempt to address the exchange rate puzzles. Specifically, it discusses the nonlinear and Bayesian econometric techniques, dynamic general equilibrium models, and the market microstructure approach that have been designed to address the three exchange rate puzzles, namely, the Purchasing Power Parity (PPP) puzzle, the exchange rate disconnect puzzle and the exchange rate determination puzzle. The paper concludes that the exchange rate puzzles are likely to be less puzzling, if researchers decide to move to nonlinear econometric frameworks and micro-founded general equilibrium models.

International macroeconomics continues to have a menu of puzzles that requires new theoretical and empirical explanations. Obstfeld and Rogoff (2000) have identified six major puzzles of international macroeconomics. Four of these relate to exchange rate economics and they are the Purchasing Power Parity (PPP) puzzle, the exchange rate disconnect puzzle, the exchange rate determination puzzle, and the forward premium puzzle.

This paper is motivated by the basic recognition that there continues to be a need to find solutions to major exchange rate puzzles mentioned above, and the importance of understanding them better. For this though, we need to realize where the current literature stands. In this paper, we provide a comprehensive literature review of the recent theoretical and empirical developments in the subject, aimed at resolving these puzzles. In the context of this paper though, the puzzles of interest are the PPP puzzle, the exchange rate disconnect puzzle, and the exchange rate determination puzzle.

We mainly assess the research output of the 1990s to the present period. The motivation for this approach is that focusing excessively on the studies undertaken in the mid 1980s and earlier periods—that is, prior to the advent of theoretical general equilibrium models in the context of open economies, and cointegration and related techniques that
revolutionized the econometric analysis in the presence of unknown or known structural breaks—seems unnecessary in the light of the modern micro-founded frameworks and new empirical tests that transcend the high probability of committing Type II error. Moreover, it seems pointless to emphasize studies which used linear empirical methods that lacked proper theoretical foundations and had low power, which, in retrospect, render detailed interpretation meaningless.

Monetary Economics Journal, Exchange Rate Puzzles, Empirical Developments, Bayesian Econometric Techniques, Nonlinear Econometric Frameworks, International Macroeconomics, Open Economies, Zero Normal Distributions, International Financial Markets, International Bonds, Domestic Firms.