Maggiori, Matteo, and Xavier Gabaix. “International Liquidity and Exchange Rate Dynamics.” Quarterly Journal of Economics 130, no. 3 (2015): 1369-1420

We provide a theory of the determination of exchange rates based on capital flows in imperfect financial markets. Capital flows drive exchange rates by altering the balance sheets of financiers that bear the risks resulting from international imbalances in the demand for financial assets. Such alterations to their balance sheets cause financiers to change their required compensation for holding currency risk, thus affecting both the level and volatility of exchange rates. Our theory of exchange rate determination in imperfect financial markets not only helps rationalize the empirical disconnect between exchange rates and traditional macroeconomic fundamentals, it also has real consequences for output and risk sharing. Exchange rates are sensitive to imbalances in financial markets and seldom perform the shock absorption role that is central to traditional theoretical macroeconomic analysis. Our framework is flexible; it accommodates a number of important modeling features within an imperfect financial market model, such as nontradables, production, money, sticky prices or wages, various forms of international pricing-to-market, and unemployment.

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Matteo Maggiori is an Assistant Professor of Economics at Harvard University. His research focuses on finance and international macroeconomics.  His research topics have included the analysis of exchange rate dynamics, the international financial system, bubbles, and very long-run discount rates.  He is a faculty research fellow at the National Bureau of Economic Research and a research affiliate at the Center for Economic Policy Research.

His research has been funded by the National Science Foundation, selected for the 2012 Review of Economic Studies May Meetings (European Tour), and won the 2013 AQR Insight Award.