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Model misspecification, learning and the exchange rate disconnect puzzle

Author
Organization
Abstract
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 US-UK post-Bretton Woods 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 tilts the balance of our findings slightly towards rational expectations and away from the learning hypothesis.
Keywords
INFLATION-EXPECTATIONS, EMPIRICAL-EVIDENCE, MONETARY APPROACH, MARKET, FUNDAMENTALS, UNCERTAINTY, VOLATILITY, FIT, exchange rate, disconnect, misspecification, learning

Citation

Please use this url to cite or link to this publication:

MLA
Lewis, Vivien, and Agniezska Markiewicz. “Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle.” B E JOURNAL OF MACROECONOMICS 9.1 (2009): 13–24. Print.
APA
Lewis, V., & Markiewicz, A. (2009). Model misspecification, learning and the exchange rate disconnect puzzle. B E JOURNAL OF MACROECONOMICS, 9(1), 13–24.
Chicago author-date
Lewis, Vivien, and Agniezska Markiewicz. 2009. “Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle.” B E Journal of Macroeconomics 9 (1): 13–24.
Chicago author-date (all authors)
Lewis, Vivien, and Agniezska Markiewicz. 2009. “Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle.” B E Journal of Macroeconomics 9 (1): 13–24.
Vancouver
1.
Lewis V, Markiewicz A. Model misspecification, learning and the exchange rate disconnect puzzle. B E JOURNAL OF MACROECONOMICS. 2009;9(1):13–24.
IEEE
[1]
V. Lewis and A. Markiewicz, “Model misspecification, learning and the exchange rate disconnect puzzle,” B E JOURNAL OF MACROECONOMICS, vol. 9, no. 1, pp. 13–24, 2009.
@article{954521,
  abstract     = {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 US-UK post-Bretton Woods 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 tilts the balance of our findings slightly towards rational expectations and away from the learning hypothesis.},
  articleno    = {13},
  author       = {Lewis, Vivien and Markiewicz, Agniezska},
  issn         = {1935-1690},
  journal      = {B E JOURNAL OF MACROECONOMICS},
  keywords     = {INFLATION-EXPECTATIONS,EMPIRICAL-EVIDENCE,MONETARY APPROACH,MARKET,FUNDAMENTALS,UNCERTAINTY,VOLATILITY,FIT,exchange rate,disconnect,misspecification,learning},
  language     = {eng},
  number       = {1},
  pages        = {13:13--13:24},
  title        = {Model misspecification, learning and the exchange rate disconnect puzzle},
  volume       = {9},
  year         = {2009},
}

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