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Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle

  • Vivien Lewis and Agnieszka Markiewicz
Published/Copyright: April 24, 2009
The B.E. Journal of Macroeconomics
From the journal The B.E. Journal of Macroeconomics Volume 9 Issue 1

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: exchange rate; disconnect; misspecification; learning
Published Online: 2009-4-24

©2011 Walter de Gruyter GmbH & Co. KG, Berlin/Boston

Articles in the same Issue

  1. Contributions Article
  2. Monetary Policy and Central Bank Balance Sheet Concerns
  3. The Transmission of Foreign Interest Rate Shocks to a Small-Open Economy: The Role of External Debt and Financial Integration
  4. Money and Barter under Private Information
  5. The Cost of Cyclical Mortality
  6. Interest Rate Conundrum
  7. Competitive Search Equilibrium with Private Information on Monetary Shocks
  8. Rational Inattention and Aggregate Fluctuations
  9. Optimal Monetary Policy in a Financially Fragile Economy
  10. Settlement Systems
  11. A Model of Sequential City Growth
  12. A Neoclassical Analysis of the Postwar Japanese Economy
  13. Empirics of Strategic Interdependence: The Case of the Racial Tipping Point
  14. Does Model Uncertainty Justify Conservatism? Robustness and the Delegation of Monetary Policy
  15. Can Financial Frictions Help Explain the Performance of the U.S. Fed?
  16. To Work or Not to Work: Did Tax Reforms Affect Labor Force Participation of Married Couples?
  17. Foreign Aid, Donor Fragmentation, and Economic Growth
  18. The Response of Household Expenditure to Anticipated Income Changes: Bonus Payments and the Seasonality of Consumption in Japan
  19. Of Nutters and Doves
  20. Topics Article
  21. Fiscal Shocks and Real Rigidities
  22. On Balance Sheets, Idiosyncratic Risk and Aggregate Volatility
  23. Endogenous Liquidity and Currency Unions
  24. Oil Matters: Real Input Prices and U.S. Unemployment Revisited
  25. Financial Development and Pay-As-You-Go Social Security
  26. Inflation Range Targets with Hard Edges
  27. Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle
  28. Estimates of the Marginal Product of Capital, 1970-2000
  29. Examining Sectoral Co-Movement in Estimated Nominal Rigidities Models
  30. The Burden Sharing of Pollution Abatement Costs in Multi-Regional Open Economies
  31. Optimal Monetary Policy with a Convex Phillips Curve
  32. Cointegration and Asymmetric Adjustment: Some New Evidence Concerning the Behavior of the U.S. Current Account
  33. Risk-Adjusted Forecasts of Oil Prices
  34. Evaluating Communication Strategies for Public Agencies: Transparency, Opacity, and Secrecy
  35. The Source of UK Historical Economic Fluctuations: An Analysis Using Long-Run Restrictions
  36. Inflation Bias with Dynamic Phillips Curves and Impatient Policy Makers
  37. Regime Switches in GDP Growth and Volatility: Some International Evidence and Implications for Modeling Business Cycles
  38. What Drives Personal Consumption? The Role of Housing and Financial Wealth
  39. Dynamic Optimal Taxation with Human Capital
  40. Unemployment and Productivity, Slowdowns and Speed-Ups: Evidence Using Common Shifts
  41. Unions, Wage Setting and Monetary Policy Uncertainty
  42. Taxing Overtime or Subsidizing Employment
  43. Transitional Dynamics in the Solow-Swan Growth Model with AK Technology and Logistic Population Change
  44. Inflation Targeting: A Framework for Communication
  45. Advances Article
  46. Total Factor Productivity and Labor Reallocation: The Case of the Korean 1997 Crisis
  47. Inferential Expectations
https://doi.org/10.2202/1935-1690.1854
Keywords for this article
exchange rate; disconnect; misspecification; learning

Articles in the same Issue

  1. Contributions Article
  2. Monetary Policy and Central Bank Balance Sheet Concerns
  3. The Transmission of Foreign Interest Rate Shocks to a Small-Open Economy: The Role of External Debt and Financial Integration
  4. Money and Barter under Private Information
  5. The Cost of Cyclical Mortality
  6. Interest Rate Conundrum
  7. Competitive Search Equilibrium with Private Information on Monetary Shocks
  8. Rational Inattention and Aggregate Fluctuations
  9. Optimal Monetary Policy in a Financially Fragile Economy
  10. Settlement Systems
  11. A Model of Sequential City Growth
  12. A Neoclassical Analysis of the Postwar Japanese Economy
  13. Empirics of Strategic Interdependence: The Case of the Racial Tipping Point
  14. Does Model Uncertainty Justify Conservatism? Robustness and the Delegation of Monetary Policy
  15. Can Financial Frictions Help Explain the Performance of the U.S. Fed?
  16. To Work or Not to Work: Did Tax Reforms Affect Labor Force Participation of Married Couples?
  17. Foreign Aid, Donor Fragmentation, and Economic Growth
  18. The Response of Household Expenditure to Anticipated Income Changes: Bonus Payments and the Seasonality of Consumption in Japan
  19. Of Nutters and Doves
  20. Topics Article
  21. Fiscal Shocks and Real Rigidities
  22. On Balance Sheets, Idiosyncratic Risk and Aggregate Volatility
  23. Endogenous Liquidity and Currency Unions
  24. Oil Matters: Real Input Prices and U.S. Unemployment Revisited
  25. Financial Development and Pay-As-You-Go Social Security
  26. Inflation Range Targets with Hard Edges
  27. Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle
  28. Estimates of the Marginal Product of Capital, 1970-2000
  29. Examining Sectoral Co-Movement in Estimated Nominal Rigidities Models
  30. The Burden Sharing of Pollution Abatement Costs in Multi-Regional Open Economies
  31. Optimal Monetary Policy with a Convex Phillips Curve
  32. Cointegration and Asymmetric Adjustment: Some New Evidence Concerning the Behavior of the U.S. Current Account
  33. Risk-Adjusted Forecasts of Oil Prices
  34. Evaluating Communication Strategies for Public Agencies: Transparency, Opacity, and Secrecy
  35. The Source of UK Historical Economic Fluctuations: An Analysis Using Long-Run Restrictions
  36. Inflation Bias with Dynamic Phillips Curves and Impatient Policy Makers
  37. Regime Switches in GDP Growth and Volatility: Some International Evidence and Implications for Modeling Business Cycles
  38. What Drives Personal Consumption? The Role of Housing and Financial Wealth
  39. Dynamic Optimal Taxation with Human Capital
  40. Unemployment and Productivity, Slowdowns and Speed-Ups: Evidence Using Common Shifts
  41. Unions, Wage Setting and Monetary Policy Uncertainty
  42. Taxing Overtime or Subsidizing Employment
  43. Transitional Dynamics in the Solow-Swan Growth Model with AK Technology and Logistic Population Change
  44. Inflation Targeting: A Framework for Communication
  45. Advances Article
  46. Total Factor Productivity and Labor Reallocation: The Case of the Korean 1997 Crisis
  47. Inferential Expectations
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