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Animal spirits in the foreign exchange market

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  • De Grauwe, Paul
  • Rovira Kaltwasser, Pablo

Abstract

It is traditionally assumed in finance models that the fundamental value of an asset is known with certainty. In this paper we depart from that assumption. We propose a simple model of the exchange rate in which agents have biased and unbiased beliefs about the fundamental rate. We show that such a model produces waves of optimism and pessimism unrelated to the underlying fundamental value. In addition, the model shows that in a world characterized by the existence of heterogeneous beliefs about the fundamental, exchange rate movements can be remarkably complex even if only fundamentalist traders operate in the market.

Suggested Citation

  • De Grauwe, Paul & Rovira Kaltwasser, Pablo, 2012. "Animal spirits in the foreign exchange market," Journal of Economic Dynamics and Control, Elsevier, vol. 36(8), pages 1176-1192.
    • Handle: RePEc:eee:dyncon:v:36:y:2012:i:8:p:1176-1192
    DOI: 10.1016/j.jedc.2012.03.008
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    More about this item

    Keywords

    Foreign exchange market; Behavioral finance; Uncertainty about fundamentals;
    All these keywords.

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • C62 - Mathematical and Quantitative Methods - - Mathematical Methods; Programming Models; Mathematical and Simulation Modeling - - - Existence and Stability Conditions of Equilibrium

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