Rational Expectation, and Efficient Foreign Exchange Market

In this chapter, we have explained that using the adaptive expectation to model expectation in applied studies, as it was done by early writers in the 1950s, results in serial correlation problems. We have, therefore, employed the rational expectation hypothesis to correct the autocorrelation problem which the adaptive expectation associated with the systematic errors introduce in such studies. We have also explained the rational expectation concept in detail, proved it, and illustrated the solution procedure by solving some rational expectation problems. We then modeled expected demand for currency assets with rational expectation hypothesis and set problems with the said rational expectation hypothesis for readers to practice. We have shown that the rational expectation hypothesis eliminates systematic errors which plague distributed lag models. We have used rational expectation hypothesis to model expected return of assets schedules for both domestic and foreign markets, which is then used to determine equilibrium exchange rates and interest rates, in response to monetary and fiscal policy changes in both domestic and foreign countries. We have used the rational expectation model to show that the foreign exchange market is efficient. However, we have also shown that, in countries which do not have forward markets, a common observation in most developing countries, the foreign exchange market is weak-form efficient when foreign exchange rates exhibit random walk behavior.