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Announcement effects on exchange rate movements: continuity as a selection criterion among the REE

  • Bask , Mikael

    ()

    (Bank of Finland Research)

The aim of this paper is to analyse the announcement effects on exchange rate movements using the basic asset pricing model, where currency trade is partly determined by technical trading in the form of moving averages since it is the most commonly used technique according to questionnaire surveys. Specifically, the announcement and implementation of temporary as well as permanent monetary policy are analysed, where the exchange rate model developed is summarised in a linear difference equation in current exoge-nous fundamentals, a large number of lags of the endogenous exchange rate and time-t dating of exchange rate expectations. However, since there are a large number of rational expectations equilibria, continuity is proposed as a selection criterion among the equilibria, meaning that the parameter for the time-t – 1 ex-change rate should have the limit 0 when there is no technical trading to have an economically meaning-ful equilibrium. It turns out that there is a unique rational expectations equilibrium that satisfy the conti-nuity criterion, and focusing on this equilibrium, it is shown that the exchange rate is much more sensitive to changes in money supply than when technical trading is absent in currency trade. This result is impor-tant since it sheds light on the so-called exchange rate disconnect puzzle in international finance.

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File URL: http://www.suomenpankki.fi/en/julkaisut/tutkimukset/keskustelualoitteet/Documents/0606netti.pdf
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Paper provided by Bank of Finland in its series Research Discussion Papers with number 6/2006.

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Length: 47 pages
Date of creation: 07 Jun 2006
Date of revision:
Handle: RePEc:hhs:bofrdp:2006_006
Contact details of provider: Postal: Bank of Finland, P.O. Box 160, FI-00101 Helsinki, Finland
Web page: http://www.suomenpankki.fi/en/

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  1. Bask, Mikael, 2006. "Adaptive learning in an expectational difference equation with several lags: selecting among learnable REE," Research Discussion Papers 7/2006, Bank of Finland.
  2. Menkhoff, Lukas, 1997. "Examining the Use of Technical Currency Analysis," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 2(4), pages 307-18, October.
  3. Lui, Yu-Hon & Mole, David, 1998. "The use of fundamental and technical analyses by foreign exchange dealers: Hong Kong evidence," Journal of International Money and Finance, Elsevier, vol. 17(3), pages 535-545, June.
  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. Oberlechner, Thomas, 2001. "Importance of Technical and Fundamental Analysis in the European Foreign Exchange Market," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 6(1), pages 81-93, January.
  6. Cheung, Yin-Wong & Chinn, Menzie David, 2001. "Currency traders and exchange rate dynamics: a survey of the US market," Journal of International Money and Finance, Elsevier, vol. 20(4), pages 439-471, August.
  7. Frankel, Jeffrey A & Froot, Kenneth A, 1986. "Understanding the U.S. Dollar in the Eighties: The Expectations of Chartists and Fundamentalists," The Economic Record, The Economic Society of Australia, vol. 0(0), pages 24-38, Supplemen.
  8. Bennett T. McCallum, 1981. "On Non-Uniqueness in Rational Expectations Models: An Attempt at Perspective," NBER Working Papers 0684, National Bureau of Economic Research, Inc.
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