Noise traders, exchange rate disconnect puzzle, and the Tobin tax

This paper proposes a framework to explain the "exchange rate disconnect puzzle". Two types of foreign exchange traders, rational traders and noise traders are introduced into a sticky-price general-equilibrium model. The presence of noise traders creates deviations from the uncovered interest parity. Combined with local currency pricing and consumption-smoothing behavior, our model can help to explain the "disconnect puzzle". The excess exchange rate volatility caused by noise traders can be reduced by the 'Tobin tax'. However, the effect of the 'Tobin tax' depends on the market structure and the interaction between the Tobin tax and other trading costs.