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On the Consistency of Short-run and Long-run Exchange Rate Expectations

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  • Kenneth A. Froot
  • Takatoshi Ito

Abstract

This paper examines whether short-term exchange rate expectations move "too much" by comparing them with long-term expectations. We develop a set of nonlinear restrictions linking expectations at different forecast horizons. The restrictions impose consistency, a property weaker than rationality. We use ex- change rate survey data to measure expectations and then test whether consistency holds. The data show that a current, positive exchange rate shock leads agents to expect a higher long-run future spot rate when iterating forward their short-term expectations than when thinking directly about the long run. In this sense short-horizon expectations may overreact to current exchange rate changes.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2577.

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Date of creation: May 1988
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Publication status: published as Froot, Kenneth A. and Takatoshi Ito. "On the Consistency of Short-run and Long-run Exchange Rate Expectations." Journal of International Money and Finance, Vol. 8, no. 4, pp. 487-510, (December 1989).
Handle: RePEc:nbr:nberwo:2577

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  1. Dominguez, Kathryn M., 1986. "Are foreign exchange forecasts rational? : New evidence from survey data," Economics Letters, Elsevier, vol. 21(3), pages 277-281.
  2. Hodrick, Robert J., 1989. "Risk, uncertainty, and exchange rates," Journal of Monetary Economics, Elsevier, vol. 23(3), pages 433-459, May.
  3. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  4. Frankel, Jeffrey A & Froot, Kenneth A, 1987. "Using Survey Data to Test Standard Propositions Regarding Exchange Rate Expectations," American Economic Review, American Economic Association, vol. 77(1), pages 133-53, March.
  5. Paul R. Krugman, 1985. "Is the strong dollar sustainable?," Proceedings - Economic Policy Symposium - Jackson Hole, Federal Reserve Bank of Kansas City, pages 103-155.
  6. Thomas J. Sargent, 1978. "A note on maximum likelihood estimation of the rational expectations model of the term structure," Staff Report 26, Federal Reserve Bank of Minneapolis.
  7. James M. Poterba & Lawrence H. Summers, 1987. "Mean Reversion in Stock Prices: Evidence and Implications," NBER Working Papers 2343, National Bureau of Economic Research, Inc.
  8. Jeffrey A. Frankel & Kenneth A. Froot, 1985. "Using Survey Data to Test Some Standard Propositions Regarding Exchange Rate Expectations," NBER Working Papers 1672, National Bureau of Economic Research, Inc.
  9. Rubinstein, Mark, 1974. "An aggregation theorem for securities markets," Journal of Financial Economics, Elsevier, vol. 1(3), pages 225-244, September.
  10. Fama, Eugene F., 1984. "Forward and spot exchange rates," Journal of Monetary Economics, Elsevier, vol. 14(3), pages 319-338, November.
  11. Andrew W. Lo, A. Craig MacKinlay, 1988. "Stock Market Prices do not Follow Random Walks: Evidence from a Simple Specification Test," Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 41-66.
  12. Kyle, Albert S, 1989. "Informed Speculation with Imperfect Competition," Review of Economic Studies, Wiley Blackwell, vol. 56(3), pages 317-55, July.
  13. Whitney K. Newey & Kenneth D. West, 1986. "A Simple, Positive Semi-Definite, Heteroskedasticity and AutocorrelationConsistent Covariance Matrix," NBER Technical Working Papers 0055, National Bureau of Economic Research, Inc.
  14. 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.
  15. Meese, Richard A, 1986. "Testing for Bubbles in Exchange Markets: A Case of Sparkling Rates?," Journal of Political Economy, University of Chicago Press, vol. 94(2), pages 345-73, April.
  16. Hansen, Lars Peter, 1982. "Large Sample Properties of Generalized Method of Moments Estimators," Econometrica, Econometric Society, vol. 50(4), pages 1029-54, July.
  17. Maurice Obstfeld, 1987. "Peso Problems, Bubbles, and Risk in the Empirical Assessment of Exchange-Rate Behavior," NBER Working Papers 2203, National Bureau of Economic Research, Inc.
  18. Huizinga, John, 1987. "An empirical investigation of the long-run behavior of real exchange rates," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 27(1), pages 149-214, January.
  19. J. Bradford De Long & Andrei Shleifer & Lawrence H. Summers & Robert J. Waldmann, 1987. "The Economic Consequences of Noise Traders," NBER Working Papers 2395, National Bureau of Economic Research, Inc.
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