Changing Beliefs and Systematic Rational Forecast Errors with Evidence from Foreign Exchange

Karen Lewis

American Economic Review, 1989, vol. 79, issue 4, 621-36

Abstract: This paper addresses a new interpretation to the appearance, in the early 1980s, of systematic errors in forecasting the dollar exchange rate. Following a change in the process of a fundamental variable, market participants revise their beliefs about the process using Bayes' Rule. Since the market does not immediately recognize the change, forecast errors are, on average, wrong during a period when the market is rationally learning. For conservative parameter values, the learning behavior of the dollar exchange rate in the early 1980s appears consistent with about half of the dollar's underprediction implied by the forward market. Copyright 1989 by American Economic Association.

Date: 1989
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