Exchange Rate Expectations: Evidence from an Artificial Economy

Survey studies on exchange rate expectations tend to reject the rational expectations hypothesis for longer horizons. Extrapolative, adaptive and regressive expectations have been tested as alternatives, usually rejecting static expectations. The purpose of this paper is to investigate the plausibility of these alternative exchange rate expectations mechanisms in an artificial economy with traders which are heterogeneous in initial endowments, risk aversion and use of information. Artificial markets which consist of either extrapolative or adaptive expectations traders fail to reproduce statistical properties that are characteristic for empirical quarterly exchange rate series, while artificial markets with regressive expectations traders often succeed. Adaptive expectations markets are rarely weak-form efficient. Extrapolative expectations markets may be weak-form efficient, but generate too many extreme returns to be empirically plausible. Regressive expectations markets often produce exchange rate series that are similar to empirical data. The (perceived) existence of an 'anchor' seems to play an important role in the functioning of foreign exchange markets, determining the frequency of extreme exchange rate returns.