A Gravity View of Exchange Rate Disconnect∗

The exchange rate disconnect puzzle consists of two distinct sub-puzzles. On the one hand, exchange rates are much more volatile than any plausible “fundamental.” On the other hand, changes in nominal exchange rates do not appear to feed back into the macroeconomy, in particular into inflation, in the way that standard theories say they should. In this paper, I use a multi-country model with specialization and costly trade (a “gravity ” model) to analyze the feedback from exchange rates to inflation. Calibration of the model using data from 24 OECD countries over the period 1970-2003 indicates that empirically plausible trade costs can explain both qualitatively and quantitatively the failure of exchange rate volatility to feed into inflation volatility. JEL codes F12, F31, F4