Evolutionary Model of the Exchange Rate Behavior

Jasmina Arifovic

No 611, Computing in Economics and Finance 1999 from Society for Computational Economics

Abstract: I study here a model of a two-country economy where agents update their decision rules using an evolutionary algorithm consisting of imitation and experimentation. This environment, in which perfect currency substitution exists, is convenient for studies of issues relating to international capital flows where agents act as traders in the international capital markets. I show that the stationary rational-expectations equilibria of this model are unstable under this type of evolutionary adaptation, displaying persistent fluctuations in the exchange rate. The exhibited dynamics are robust with respect to changes in the parameter values of both the economic model and the evolutionary algorithm. The observed persistence in the simulated data is due to the joint effects relating to the indeterminacy of the equilibria and the dynamics generated by the evolutionary algorithm. In addition, an analytical model of the evolutionary behavior is derived. The performance of the boundedly rational agents is compared to that of the agent who bases decisions on conditional expectations (implying that the rational agent knows the exact nature of the adaptive process governing the dynamics). The first part of the discussion focuses on the environment where decisions made by rational agents have no effect on prices; in the second part, they do. The paper also examines the issue of whether boundedly rational agents make systematic errors over time. Finally, the model is calibrated to match the characteristics of the behavior of the actual exchange-rate time series.

Date: 1999-03-01
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