Model misspecification, learning and the exchange rate disconnect puzzle

Vivien Lewis and Agnieszka Markiewicz ()

No 168, Working Paper Research from National Bank of Belgium

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 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

Keywords: exchange rate; disconnect; misspecification; learning (search for similar items in EconPapers)
JEL-codes: E37 E44 F31 (search for similar items in EconPapers)
Pages: 34 pages
Date: 2009-07
New Economics Papers: this item is included in nep-cba, nep-ifn and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (5)

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Related works:
Journal Article: Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle (2009)
Working Paper: Model Misspecification, Learning and the Exchange Rate Disconnect Puzzle (2009)
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Persistent link: https://EconPapers.repec.org/RePEc:nbb:reswpp:200907-01

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