Can Market Imperfections Explain the Behavior of Exchange Rates?

Diploma Thesis by Zoe Kuehn
July 27, 2004


The answer is a clear yes. Market imperfections in both the goods and asset markets not only help to explain the short-run behavior of exchange rates but are also the driving force behind it. Indeed they constitute the key element to its understanding. Exactly which market imperfections are responsible for which features of this behavior is, however, disputed. Following one approach based on a model by Devereux and Engel [2002] this thesis will show how each market imperfection contributes to closing the enormous gap between data and theory, that is, between observable characteristics of exchange rate behavior and theoretical concepts like Purchasing Power Parity (PPP) and Uncovered Interest Rate Parity (UIRP).