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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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    1. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
    2. Wei, S.J. & Kim, J., 1999. "The Big Players in the Foreign Exchange Market: Do They Trade on Information or Noise?," Papers, Chicago - Graduate School of Business 5, Chicago - Graduate School of Business.
    3. Baxter, M. & Stockman, A.C., 1988. "Business Cycles And The Exchange Rate System: Some International Evidence," RCER Working Papers 140, University of Rochester - Center for Economic Research (RCER).
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    5. Flood, Robert P. & Rose, Andrew K., 1995. "Fixing exchange rates A virtual quest for fundamentals," Journal of Monetary Economics, Elsevier, vol. 36(1), pages 3-37, August.
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    7. Dilip Abreu & Markus K. Brunnermeier, 2003. "Bubbles and Crashes," Econometrica, Econometric Society, Econometric Society, vol. 71(1), pages 173-204, January.
    8. Taylor, Mark P. & Allen, Helen, 1992. "The use of technical analysis in the foreign exchange market," Journal of International Money and Finance, Elsevier, vol. 11(3), pages 304-314, June.
    9. 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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    12. Andrei Shleifer ad Robert W. Vishny, 1995. "The Limits of Arbitrage," Harvard Institute of Economic Research Working Papers 1725, Harvard - Institute of Economic Research.
    13. Lux, Thomas & Sornette, Didier, 2002. "On Rational Bubbles and Fat Tails," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 34(3), pages 589-610, August.
    14. 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, vol. 33(2), pages 143-165, January.
    15. Charles Engel & James Morley, 2000. "The Adjustment of Prices and the Adjustment of the Exchange Rate," Discussion Papers in Economics at the University of Washington, Department of Economics at the University of Washington 0009, Department of Economics at the University of Washington.
    16. Kurz, Mordecai, 1994. "On the Structure and Diversity of Rational Beliefs," Economic Theory, Springer, vol. 4(6), pages 877-900, October.
    17. Richard K. Lyons, 2006. "The Microstructure Approach to Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 026262205x, December.
    18. Tirole, Jean, 1982. "On the Possibility of Speculation under Rational Expectations," Econometrica, Econometric Society, Econometric Society, vol. 50(5), pages 1163-81, September.
    19. Lux, T. & M. Marchesi, . "Volatility Clustering in Financial Markets: A Micro-Simulation of Interacting Agents," Discussion Paper Serie B 437, University of Bonn, Germany, revised Jul 1998.
    20. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 84(6), pages 1161-76, December.
    21. Mordecai Kurz & Maurizio Motolese, . "Endogenous Uncertainty and Market Volatility," Working Papers, Stanford University, Department of Economics 99005, Stanford University, Department of Economics.
    22. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
    23. Kandel, Eugene & Pearson, Neil D, 1995. "Differential Interpretation of Public Signals and Trade in Speculative Markets," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(4), pages 831-72, August.
    24. 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.
    25. Garber, Peter M, 1990. "Famous First Bubbles," Journal of Economic Perspectives, American Economic Association, vol. 4(2), pages 35-54, Spring.
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