Explaining Exchange Rate Anomalies in a Model with Taylor-Rule Fundamentals and Consistent Expectations

We introduce a form of boundedly-rational expectations into a standard asset-pricing model of the exchange rate, where cross-country interest rate differentials are governed by Taylor-type rules. We postulate that agents augment a lagged-information random walk forecast with a term that relates to news about Taylor-rule fundamentals. We solve for a ?consistent expectations equilibrium,? in which the coefficient on fundamental news in the agent?s forecast rule is pinned down using the moments of observable data. The forecast errors observed by the agent are close to white noise, making it di cult for the agent to detect any misspecification. We show that the model generates volatility and persistence that is remarkably similar to that observed in monthly bilateral exchange rate data (relative to the U.S.) for Canada, Japan, and the U.K. over the period 1974 to 2012. Moreover, we show that regressions performed on model-generated data can deliver the well-documented forward premium anomaly whereby a high interest rate currency tends to appreciate, thus violating the uncovered interest rate parity condition.