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A Scapegoat Model of Exchange Rate Fluctuations

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  • Bacchetta, Philippe
  • van Wincoop, Eric

Abstract

While empirical evidence finds only a weak relationship between nominal exchange rates and macroeconomic fundamentals, forex markets participants often attribute exchange rate movements to a macroeconomic variable. The variables that matter, however, appear to change over time and one variable is typically taken as a scapegoat. For example, the current dollar weakness appears to be caused almost exclusively by the large current account deficit, while its previous strength was explained mainly by growth differentials. In this Paper, we propose an explanation of this phenomenon in a simple monetary model of the exchange rate with noisy rational expectations, where investors have heterogeneous information on some structural parameter of the economy. In this context, there may be rational confusion about the true source of exchange rate fluctuations, so that if an unobservable variable affects the exchange rate, investors may attribute this movement to some current macroeconomic fundamental. We show that this effect applies only to variables with large imbalances. The model thus implies that the impact of macroeconomic variables on the exchange rate changes over time.

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Paper provided by C.E.P.R. Discussion Papers in its series CEPR Discussion Papers with number 4268.

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Date of creation: Feb 2004
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Handle: RePEc:cpr:ceprdp:4268

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Keywords: heterogenous information; model uncertainty;

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  1. Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
  2. Bacchetta, Philippe & van Wincoop, Eric, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," CEPR Discussion Papers 3808, C.E.P.R. Discussion Papers.
  3. Olivier Jeanne & Andrew K. Rose, 2002. "Noise Trading And Exchange Rate Regimes," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 537-569, May.
  4. 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.
  5. Cheung, Yin-Wong & Chinn, Menzie David, 2001. "Currency traders and exchange rate dynamics: a survey of the US market," Journal of International Money and Finance, Elsevier, vol. 20(4), pages 439-471, August.
  6. Yin-Wong Cheung & Antonio Garcia Pascual & Menzie David Chinn, 2004. "Empirical Exchange Rate Models of the Nineties," IMF Working Papers 04/73, International Monetary Fund.
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  1. Exchange rates and scapegoats
    by Economic Logician in Economic Logic on 2012-07-20 15:02:00
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