Please use this identifier to cite or link to this item: http://hdl.handle.net/10419/144380
Authors: 
Lewis, Vivien
Markiewicz, Agnieszka
Year of Publication: 
2009
Series/Report no.: 
Working Paper Research 168
Abstract: 
Rational expectations models fail to explain the disconnect between the exchange rate and macroeconomic fundamentals. In line with survey evidence on the behaviour of foreign exchange traders, we introduce model misspecification and learning into a standard monetary model. Agents use simple forecasting rules based on a restricted information set. They learn about the parameters and performance of different models and can switch between forecasting rules. We compute the implied post-Bretton Woods US dollar-pound sterling exchange rate and show that the excess volatility of the exchange rate return can be reproduced with low values of the learning gain. Both assumptions, misspecification and learning, are necessary to generate this result. However, the implied correlations with the fundamentals are higher than in the data. Including more lags in the model tends to tip the balance of our findings slightly towards rational expectations and away from the learning hypothesis
Subjects: 
exchange rate
disconnect
misspecification
learning
JEL: 
F31
E37
E44
Document Type: 
Working Paper

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