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Exchange Rate Dynamics and Learning

  • Pierre-Olivier Gourinchas
  • Aaron Tornell

Interest rate expectations are essential for exchange rate determination. Using a unique Survey data set on interest rate forecasts from 1986 to 1995 for G7 countries, we find that interest rate shocks were significantly more persistent in sample than expected by the market. This is consistent with ff3's finding that changes in the forward rate reflect changes in exchange rate expectations. We then present a model of nominal exchange rate determination that rationalizes the forward discount puzzle and exhibits the delayed overshooting pattern found by ee: following a monetary expansion that reduces the domestic interest rate, there is a gradual depreciation of the exchange rate followed by a gradual appreciation several months later. Delayed overshooting results from (a) the interaction of learning about the current state of affairs, and the intrinsic dynamic response of interest rates to monetary shocks and (b) the discrepancy between the actual distribution of shocks in sample and its expectation by market participants. This discrepancy is consistent with rational expectations if either (a) there is a small sample or Peso problem or (b) the true structure of the economy evolves over time and agents are learning with some delay.

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Paper provided by Harvard - Institute of Economic Research in its series Harvard Institute of Economic Research Working Papers with number 1771.

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Date of creation: 1996
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Handle: RePEc:fth:harver:1771
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  1. Hellwig, Martin F., 1980. "On the aggregation of information in competitive markets," Journal of Economic Theory, Elsevier, vol. 22(3), pages 477-498, June.
  2. Grilli, Vittorio & Roubini, Nouriel, 1992. "Liquidity and exchange rates," Journal of International Economics, Elsevier, vol. 32(3-4), pages 339-352, May.
  3. Martin Eichenbaum & Charles L. Evans, 1993. "Some Empirical Evidence on the Effects of Monetary Policy Shocks on Exchange Rates," NBER Working Papers 4271, National Bureau of Economic Research, Inc.
  4. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  5. Jordi Galí & Richard Clarida, 1993. "Sources of real exchage rate fluctuations: How important are nominal shocks?," Economics Working Papers 66, Department of Economics and Business, Universitat Pompeu Fabra, revised Jan 1994.
  6. Kenneth A. Froot, 1987. "New Hope for the Expectations Hypothesis of the Term Structure of Interest Rates," NBER Working Papers 2363, National Bureau of Economic Research, Inc.
  7. Jeffrey A. Frankel and Andrew K. Rose., 1995. "A Survey of Empirical Research on Nominal Exchange Rates," Center for International and Development Economics Research (CIDER) Working Papers C95-051, University of California at Berkeley.
  8. Benjamin M. Friedman, 1978. "Interest Rate Expectations Versus Forward Rates: Evidence From An Expectations Survey," NBER Working Papers 0295, National Bureau of Economic Research, Inc.
  9. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  10. Engle, Robert F & Lilien, David M & Robins, Russell P, 1987. "Estimating Time Varying Risk Premia in the Term Structure: The Arch-M Model," Econometrica, Econometric Society, vol. 55(2), pages 391-407, March.
  11. Grier, Kevin B & Perry, Mark J, 1993. " The Effect of Money Shocks on Interest Rates in the Presence of Conditional Heteroskedasticity," Journal of Finance, American Finance Association, vol. 48(4), pages 1445-55, September.
  12. Lucas, Robert E, Jr, 1973. "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review, American Economic Association, vol. 63(3), pages 326-34, June.
  13. Wang, Jiang, 1994. "A Model of Competitive Stock Trading Volume," Journal of Political Economy, University of Chicago Press, vol. 102(1), pages 127-68, February.
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