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Model misspecification, learning and the exchange rate disconnect puzzle

  • Vivien Lewis


    (National Bank of Belgium, Research Department
    Ghent University, Department of Financial Economics)

  • Agnieszka Markiewicz


    (Erasmus University Rotterdam, Department of Economics)

Rational expectations models fail to explain the disconnect between the exchange rate and macroeconomic fundamentals. In line with survey evidence on the behaviour of foreign exchange traders, we introduce model misspecification and learning into a standard monetary model. Agents use simple forecasting rules based on a restricted information set. They learn about the parameters and performance of different models and can switch between forecasting rules. We compute the implied post-Bretton Woods US dollar-pound sterling exchange rate and show that the excess volatility of the exchange rate return can be reproduced with low values of the learning gain. Both assumptions, misspecification and learning, are necessary to generate this result. However, the implied correlations with the fundamentals are higher than in the data. Including more lags in the model tends to tip the balance of our findings slightly towards rational expectations and away from the learning hypothesis

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Paper provided by National Bank of Belgium in its series Working Paper Research with number 168.

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Length: 34 pages
Date of creation: Jul 2009
Date of revision:
Handle: RePEc:nbb:reswpp:200907-01
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