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Learning Dynamics in a Nonlinear Stochastic Model of Exchange Rates

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This paper considers a version of the Dornbusch model of exchange rate dynamics which allows a nonlinear domestic demand for foreign assets function and imperfect substitutability between domestic and foreign interest bearing assets. Expectations of exchange rate changes are modelled as adaptive with perfect foresight being obtained as a limiting case. For sufficiently rapid speed of adjustment of expectations the model is able to generate cyclical behaviour of the exchange rate and expectations of its change. In the perfect foresight limit the cycles become relaxation cycles. To this underlying model of the fundamentals a white noise "news" process is added. Agents are assumed to attempt to learn about the system dynamics and the link between such learning and exchange rate volatility is studied. Two learning scenarios are considered. In the first scenario economic agents are regarded as a uniformly well-informed group of sophisticated traders. In the second scenario a group of "naive" traders coexist with the sophisticated traders. We find that both learning scenarios lead to increased volatility. However this effect increases in proportion to the weight of the "naive" traders.

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File URL: http://www.finance.uts.edu.au/research/wpapers/wp64.pdf
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Paper provided by Finance Discipline Group, UTS Business School, University of Technology, Sydney in its series Working Paper Series with number 64.

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Date of creation: 01 May 1996
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Handle: RePEc:uts:wpaper:64

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  1. Tabellini, Guido, 1988. "Learning and the volatility of exchange rates," Journal of International Money and Finance, Elsevier, vol. 7(2), pages 243-250, June.
  2. Gray, Malcolm R & Turnovsky, Stephen J, 1979. "The Stability of Exchange Rate Dynamics under Perfect Myopic Foresight," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 20(3), pages 643-60, October.
  3. Karacaoglu, Girol & Ursprung, Heinrich W., 1988. "Exchange rate dynamics under gradual portfolio adjustment," Journal of Macroeconomics, Elsevier, vol. 10(4), pages 565-589.
  4. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  5. Hsieh, David A, 1989. "Testing for Nonlinear Dependence in Daily Foreign Exchange Rates," The Journal of Business, University of Chicago Press, vol. 62(3), pages 339-68, July.
  6. Papell, David H., 1992. "Exchange rate and price dynamics under adaptive and rational expectations: An empirical analysis," Journal of International Money and Finance, Elsevier, vol. 11(4), pages 382-396, August.
  7. Chiarella, Carl, 1990. "Excessive exchange rate variability : A possible explanation using nonlinear economic dynamics," European Journal of Political Economy, Elsevier, vol. 6(3), pages 315-352, December.
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