Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/121045
Authors: 
Filippo, Gabriele Di
Year of Publication: 
2010
Series/Report no.: 
FIW Working Paper 44
Abstract: 
The present paper provides a new explanation for the dynamics of exchange rates based on conventions that prevail among market participants. The model relies on a two states Markov switching framework: a bull state and a bear state. In the bull state, agents are optimistic and put more weight on positive news about the domestic economy inducing an appreciation of the domestic currency. In the bear state, agents are pessimistic and overweight negative news associated to the domestic economy leading to a depreciation of the domestic currency. Results show that market switches between a bull state and a bear state explain the dynamics of the euro/dollar exchange rate between January 1995 and December 2008. Besides, the model highlights the life-cycle of conventions in the foreign exchange market and provides lessons for public authorities to reduce exchange rate volatility. Eventually, the model offers a solution to the exchange rate disconnection puzzle.
Subjects: 
Exchange Rate Dynamics
Convention Theory
Imperfect
JEL: 
G10
G12
F31
Document Type: 
Working Paper

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