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A Scapegoat Model of Exchange Rate Fluctuations

  • Philippe Bacchetta

    ()

    (University of Lausanne, Studienzentrum Gerzensee and CEPR)

  • Eric van Wincoop

    ()

    (University of Virginia)

While empirical evidence finds only a weak relationship between nominal exchange rates and macroeconomic fundamentals, forex markets participants often attribute exchange rate movements to a macroeconomic variable. The variables that matter, however, appear to change over time and some variable is typically taken as a scapegoat. For example, the current dollar weakness appears to be caused almost exclusively by the large current account de cit, while its previous strength was explained mainly by growth differentials. In this paper, we propose an explanation of this phenomenon in a simple monetary model of the exchange rate with noisy rational expectations, where investors have heterogeneous information on some structural parameter of the economy. In this context, there may be rational confusion about the true source of exchange rate fluctuations, so that if an unobservable variable a ects the exchange rate, investors may attribute this movement to some current macroeconomic fundamental. We show that this effect applies only to variables with large imbalances. The model thus implies that the impact of macroeconomic variables on the exchange rate changes over time.

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Paper provided by Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 04.01.

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Length: 19
Date of creation: Jan 2004
Date of revision:
Handle: RePEc:szg:worpap:0401
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  1. Cheung, Yin-Wong & Chinn, Menzie & Garcia Pascual, Antonio, 2003. "Empirical Exchange Rate Models of the Nineties: Are Any Fit to Survive?," Santa Cruz Department of Economics, Working Paper Series qt5fc508pt, Department of Economics, UC Santa Cruz.
  2. Jeanne, Olivier & Rose, Andrew K, 1999. "Noise Trading and Exchange Rate Regimes," CEPR Discussion Papers 2142, C.E.P.R. Discussion Papers.
  3. Yin-Wong Cheung & Menzie D. Chinn, 2000. "Currency Traders and Exchange Rate Dynamics: A Survey of the U.S. Market," CESifo Working Paper Series 251, CESifo Group Munich.
  4. Philippe Bacchetta & Eric van Wincoop, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," Working Papers 03.02, Swiss National Bank, Study Center Gerzensee.
  5. Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
  6. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
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