A Scapegoat Model of Exchange Rate Fluctuations

Abstract

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 deficit, 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 affects 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.

On the unstable relationship between exchange rates and macroeconomic fundamentals

“…As rst shown by Stock and Watson (1996), and since then by many others, the phenomenon of parameter instability in macroeconomic data is widespread. 1 The same is the case for nancial data. In a survey, Pastor and Veronesi (2009) point out that \parameter uncertainty is ubiquitous in nance"and \many facts that appear ba ing at rst sight seem less puzzling once we recognize that parameters are uncertain and subject to learning".…”

“…We therefore replace the speci cation F t = f 0 t for constant parameters with the speci cation F t = f 0 t t for time-varying parameters. While for illustrative purposes we have motivated this in the context of the familiar exible price monetary model, it can also be obtained from other models that lead to the present value equation (1). One example is to replace the money market equilibrium by an interest rate rule that depends on a number of observed fundamentals.…”

Rational Inattention: A Solution to the Forward Discount Puzzle

“…A regression of the quarterly excess return on a foreign currency on the difference between the U.S. and foreign interest rate yields coefficients ranging from -1.5 to -4. 2 Moreover, as documented below, interest rate differentials continue to negatively predict the excess returns five to ten quarters ahead.…”

Model uncertainty and endogenous volatility

“…Evans and Honkapohja (1993) construct a model with multiple stable equilibria and pin down the optimal constant gain in agents' learning algorithm as an approximate Nash equilibrium. In these settings, there is an optimal gain because agents are alert to 17 Bacchetta and Van Wincoop (2004) develop a model in which agents have private signals and underparameterized forecasting models. They show that the predictive power of certain macroeconomic fundamentals may change over time as agents' higher order expectations cause them to occasionally over-react to news.…”