Monetary policy regimes and the forward bias for foreign exchange

Juan Angel Lafuente, Rafaela Perez and Jesus Ruiz

Journal of Economics and Business, 2016, vol. 85, issue C, 13-28

Abstract: This paper provides a theoretical discussion of the forward premium anomaly. We reformulate the well-known Lucas (1982) model by allowing for the existence of monetary policy regimes. The monetary supply is viewed as having two stochastic components: (a) a persistent component that reflects the preferences of the central bank regarding the long-run money supply or inflation target, and (b) a transitory component that represents short-lived interventions. To generate agents’ forecasts, we consider two scenarios: (a) consumers can distinguish the permanent and the transitory components of the money supply (complete information), and (b) consumers face a signal-extraction problem to disentangle permanent and transitory components of the money supply (incomplete information). We simulate the model from a careful estimate of the parameters involved in the model. Numerical simulations reveal that, under complete information, forward unbiasedness cannot be rejected at conventionally significant levels. However, when learning about monetary policy is incorporated, the forward bias can be reproduced without artificially assuming an unreasonable degree of risk aversion.

Keywords: Monetary policy; Regime shifts; Learning; Forward bias (search for similar items in EconPapers)
JEL-codes: E43 F31 G14 (search for similar items in EconPapers)
Date: 2016
References: Add references at CitEc
Citations: View citations in EconPapers (1)

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Working Paper: Monetary policy regimes and the forward bias for foreign exchange (2012)
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jebusi:v:85:y:2016:i:c:p:13-28

DOI: 10.1016/j.jeconbus.2016.02.005

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