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Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle

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  • Lewis Vivien

    ()
    (Ghent University and National Bank of Belgium)

  • Markiewicz Agnieszka

    ()
    (Erasmus University Rotterdam)

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 US-UK post-Bretton Woods 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 tilts the balance of our findings slightly towards rational expectations and away from the learning hypothesis.

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Bibliographic Info

Article provided by De Gruyter in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 9 (2009)
Issue (Month): 1 (April)
Pages: 1-24

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Handle: RePEc:bpj:bejmac:v:9:y:2009:i:1:n:13

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Cited by:
  1. Philippe Bacchetta & Eric van Wincoop, 2011. "Modeling Exchange Rates with Incomplete Information," Cahiers de Recherches Economiques du Département d'Econométrie et d'Economie politique (DEEP) 11.03, Université de Lausanne, Faculté des HEC, DEEP.
  2. Agnieszka Markiewicz, 2010. "Monetary Policy, Model Uncertainty and Exchange Rate Volatility," CESifo Working Paper Series 2949, CESifo Group Munich.

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