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Fundamental and Non-Fundamental Equilibria in the Foreign Exchange Market. A Behavioural Finance Framework

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  • Paul de Grauwe
  • Roberto Dieci
  • Marianna Grimaldi
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    Abstract

    We develop a simple model of the exchange rate in which agents optimize their portfolio and use different forecasting rules. They check the profitability of these rules ex post and select the more profitable one. This model produces two kinds of equilibria, a fundamental and a bubble one. In a stochastic environment the model generates a complex dynamics in which bubbles and crashes occur at unpredictable moments. We contrast these ”behavioural” bubbles with ”rational” bubbles.

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    File URL: http://www.cesifo-group.de/portal/page/portal/DocBase_Content/WP/WP-CESifo_Working_Papers/wp-cesifo-2005/wp-cesifo-2005-03/cesifo1_wp1431.pdf
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    Bibliographic Info

    Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1431.

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    Date of creation: 2005
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    Handle: RePEc:ces:ceswps:_1431

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    Keywords: exchange rate; bounded rationality; heterogeneous agents; bubbles and crashes; complex dynamics; basins of attraction;

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    3. Shang-Jin Wei & Jungshik Kim, 1999. "The Big Players in the Foreign Exchange Market: Do They Trade on Information or Noise?," CID Working Papers, Center for International Development at Harvard University 5, Center for International Development at Harvard University.
    4. Thomas Lux & Didier Sornette, 1999. "On Rational Bubbles and Fat Tails," Discussion Paper Serie B, University of Bonn, Germany 458, University of Bonn, Germany.
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    8. Shleifer, Andrei & Vishny, Robert W, 1997. " The Limits of Arbitrage," Journal of Finance, American Finance Association, American Finance Association, vol. 52(1), pages 35-55, March.
    9. Brunnermeier, Markus K., 2001. "Asset Pricing under Asymmetric Information: Bubbles, Crashes, Technical Analysis, and Herding," OUP Catalogue, Oxford University Press, Oxford University Press, number 9780198296980, October.
    10. Lux, T. & M. Marchesi, . "Volatility Clustering in Financial Markets: A Micro-Simulation of Interacting Agents," Discussion Paper Serie B, University of Bonn, Germany 437, University of Bonn, Germany, revised Jul 1998.
    11. Marianne Baxter & Alan C. Stockman, 1988. "Business Cycles and the Exchange Rate System: Some International Evidence," NBER Working Papers 2689, National Bureau of Economic Research, Inc.
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    13. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, Springer, vol. 4(6), pages 877-900, October.
    14. Mordecai Kurz & Maurizio Motolese, . "Endogenous Uncertainty and Market Volatility," Working Papers, Stanford University, Department of Economics 99005, Stanford University, Department of Economics.
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    17. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, Econometric Society, vol. 50(5), pages 1163-81, September.
    18. Daniel Kahneman & Jack L. Knetsch & Richard H. Thaler, 1991. "Anomalies: The Endowment Effect, Loss Aversion, and Status Quo Bias," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 5(1), pages 193-206, Winter.
    19. Jon Faust & John H. Rogers & Eric Swanson & Jonathan H. Wright, 2003. "Identifying the Effects of Monetary Policy Shocks on Exchange Rates Using High Frequency Data," NBER Working Papers 9660, National Bureau of Economic Research, Inc.
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    21. De Long, J. Bradford & Shleifer, Andrei & Summers, Lawrence H. & Waldmann, Robert J., 1990. "Noise Trader Risk in Financial Markets," Scholarly Articles 3725552, Harvard University Department of Economics.
    22. Lux, Thomas, 1998. "The socio-economic dynamics of speculative markets: interacting agents, chaos, and the fat tails of return distributions," Journal of Economic Behavior & Organization, Elsevier, Elsevier, vol. 33(2), pages 143-165, January.
    23. Richard K. Lyons, 2006. "The Microstructure Approach to Exchange Rates," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 026262205x, December.
    24. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, Elsevier, vol. 3(4), pages 387-389.
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