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Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle

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Author Info
Vivien Lewis (Ghent University and National Bank of Belgium)
Agnieszka Markiewicz (Erasmus University Rotterdam)

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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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File URL: http://www.bepress.com/cgi/viewcontent.cgi?article=1854&context=bejm
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Publisher Info
Article provided by Berkeley Electronic Press in its journal The B.E. Journal of Macroeconomics.

Volume (Year): 9 (2009)
Issue (Month): 1 ()
Pages:
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Handle: RePEc:bpj:bejmac:v:9:y:2009:i:1:n:13

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Web page: http://www.bepress.com/bejm

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Related research
Keywords: exchange rate; disconnect; misspecification; learning;

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Find related papers by JEL classification:
F31 - International Economics - - International Finance - - - Foreign Exchange
E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy

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