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The Dollar as an Irrational Speculative Bubble: A Tale of Fundamentalisists

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  • Jeffrey A. Frankel
  • Kenneth A. Froot

Abstract

Several recent developments have inspired us to consider a non-standard model of the dollar as a speculative bubble without the constraint of fully rational expectations: (1) the dollar continued to rise in 1984 after real interest rate differentials and other fundamentals began moving the wrong way; (2) the results of market efficiency tests imply, that the rationally expected rate of dollar depreciation has been less than the forward discount; (3) Krugman-Marris current account calculations suggest that the rationally expected rate of depreciation is greater than the forward discount; (4) survey data show an expected rate of depreciation that is also greater than the forward discount; (5) the hypothesis of a "safe-haven" shift into U.S. assets and a decrease in the U.S. risk premium, which would explain some of the foregoing, is contradicted by a decline in the differential between off shore interest rates (covered) and U.S. interest rates. Our model features three classes of actors: fundamentalists, chartists and portfolio managers. Fundamentalists forecast a depreciation of the dollar based on an overshooting model that would be rational if there were no chartists. Chartists extrapolate recent trends based on an information set that includes no fundamentals. Portfolio managers take positions in the market, and thus determine the exchange rate, based on expectations that area weighted average of the fundamentalists and chartists. The first stage of the dollar appreciation after 1980 is explained by increases in real interest differentials. The second stage is explained by the endogenous takeoff of a speculative bubble when the fundamentalists have mis-forecast for so long that they have lost credibility. In 1985, the dollar may have entered a third stage in which an ever-worsening current account deficit begins a reversal of the bubble.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1854.

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Date of creation: Dec 1987
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Handle: RePEc:nbr:nberwo:1854

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  1. McCormick, Frank, 1979. "Covered Interest Arbitrage: Unexploited Profits? Comment," Journal of Political Economy, University of Chicago Press, vol. 87(2), pages 411-17, April.
  2. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  3. Frankel, Jeffrey & Engel, Charles M., 1984. "Do asset-demand functions optimize over the mean and variance of real returns? A six-currency test," Journal of International Economics, Elsevier, vol. 17(3-4), pages 309-323, November.
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  12. Paul R. Krugman, 1985. "Is the strong dollar sustainable?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 103-155.
  13. Benjamin M. Friedman, 1985. "Implications of the U.S. net capital inflow," Proceedings, Federal Reserve Bank of St. Louis, pages 137-167.
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  18. 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.
  19. Rodriguez, Carlos Alfredo, 1980. "The Role of Trade Flows in Exchange Rate Determination: A Rational Expectations Approach," Journal of Political Economy, University of Chicago Press, vol. 88(6), pages 1148-58, December.
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Cited by:
  1. Juann H. Hung, 1995. "Intervention strategies and exchange rate volatility: a noise trading perspective," Research Paper 9515, Federal Reserve Bank of New York.
  2. A. Bénassy-Quéré & S. Larribeau & R. MacDonald, 1999. "Models of exchange rate expectations : heterogeneous evidence from Panel data," THEMA Working Papers 99-05, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
  3. Michel Beine & Agnès Bénassy-Quéré & Hélène Colas, 2003. "Imitation Amongst Exchange-Rate Forecasters: Evidence from Survey Data," THEMA Working Papers 2003-39, THEMA (THéorie Economique, Modélisation et Applications), Université de Cergy-Pontoise.
  4. Alfarano, Simone & Lux, Thomas, 2005. "A noise trader model as a generator of apparent financial power laws and long memory," Economics Working Papers 2005,13, Christian-Albrechts-University of Kiel, Department of Economics.
  5. Alfarano, Simone & Lux, Thomas, 2003. "A minimal noise trader model with realistic time series properties," Economics Working Papers 2003,15, Christian-Albrechts-University of Kiel, Department of Economics.

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