The Japanese Economic Review Vol. 56, No. 1, March 2005 –1– © Japanese Economic Association 2005. Blackwell Publishing, Ltd. Oxford, UK JERE The Japanese Economic Review 1468-5876 Japanese Economic Association 2004 March 2004 56 1 ORIGINAL ARTICLE The Japanese Economic Review T. Ito: The Exchange Rate in the Japanese Economy THE EXCHANGE RATE IN THE JAPANESE ECONOMY: THE PAST, PUZZLES, AND PROSPECTS* By TAKATOSHI ITO University of Tokyo and NBER Selected topics in the literature on the exchange rate, in particular the yen, are reviewed from the viewpoint of some academic/practical puzzles. A survey is provided of past work covering use of the yen on PPP, covered and uncovered interest rate parity, the unbiasedness of expected future exchange rates, volatility spillover across borders and the effectiveness of intervention. The role of the yen in the international financial structure and its future role in global and regional financial markets are discussed. JEL Classification Numbers: F31, F33, F37. 1. Introduction The foreign exchange rate is a fascinating variable in economics. Although many consumers and businesses are keen on protecting values of their assets or making money from exchange rate movements, economists find it difficult to explain these movements, let alone predict their future path. The objective of this paper is to highlight some of the tensions between theory and empirical findings, as well as between theory and the real world, with a special focus on the Japanese economy and the yen. This is not the first paper to point out incon- sistencies between theory and empirical findings. A long list of “puzzles” and “anomalies”— empirical findings contradicting theoretical predictions—is available in the literature; see e.g. Obstfeld and Rogoff (2000) for “six major puzzles in international macroeconomics”, and a survey of puzzles by Lewis (1995) in the Handbook of International Economics; see also Rogoff (1996) on the purchasing power parity puzzle and Froot and Thaler (1990) on “anomalies” in the foreign exchange literature. In this paper I propose adding some new puzzles to the list as well as reviewing old puzzles in the context of the yen and the Japanese economy. In the last section, the future role of the yen is considered. In theory, the exchange rate is a nexus of determining relative prices of goods and ser- vices and relative prices of assets in different countries. By the identity of the balance of payments, the current account gap is equivalent to capital account imbalances (plus inter- vention by the authorities). Under the flexible exchange rate regime, the exchange rate can be influenced by, and can in turn influence, trade account balances and capital account balances; but it is difficult to model the exchange rate playing this dual role, especially with a definite direction of causality between the exchange rate and macro-finance funda- mentals. In many theoretical models of open macroeconomics, the exchange rate is regarded as one of the endogenous variables of a large macroeconomic system, while the exchange rate is definitely an asset price in international finance. The former implies that the exchange rate is a slow-moving variable similar to consumption, investment and * This essay is based on the Presidential Address to the Japan Economic Association (JEA), delivered at its Annual Conference on 25 September 2004 at Okayama University, Japan. I am grateful to Professors Yuko Hashimoto, Masahiro Kawai, Eiji Ogawa, Shigenori Shiratsuka and Tsutomu Watanabe. Research support by JSPS Grants in aid for Scientific Research, No. 15203008, is gratefully acknowledged.