Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?

Philippe Bacchetta and Eric van Wincoop

No 03.02, Working Papers from Swiss National Bank, Study Center Gerzensee

Abstract: Empirical evidence shows that macroeconomic fundamentals have little explanatory power for nominal exchange rates. On the other hand, the recent "microstructure approach to exchange rates" has shown that most exchange rate volatility at short to medium horizons is related to order flows. This suggests that investors heterogeneity might be key to understanding exchange rate dynamics, in contrast to the common representative agent approach in macroeconomic models of exchange rate determination. To explore this issue, we introduce investor heterogeneity into an otherwise standard monetary model of exchange rate determination. There are two types of heterogeneity: dispersed information about fundamentals and non-fundamentals based heterogeneity (e.g., liquidity traders). We show that information dispersion leads to magnification and endogenous persistence of the impact of non-fundamentals trade on the exchange rate, both resulting from rational confusion about the source of exchange rate fluctuations. Higher order expectations, familiar from Keynes' "beauty contest", partly contribute to these results. The implications of the model are consistent with the evidence on the relationship between exchange rates and fundamentals: (i) fundamentals play little role in explaining exchange rate movements in the short to medium run, (ii) over longer horizons the exchange rate is primarily driven by fundamentals, (iii) exchange rate changes are a weak predictor for future fundamentals.

Pages: 51 pages
Date: 2003-02
New Economics Papers: this item is included in nep-dge, nep-fin, nep-ifn and nep-pke
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (37)

Downloads: (external link)
http://www.szgerzensee.ch/fileadmin/Dateien_Anwend ... g_papers/wp-0302.pdf Full text (application/pdf)
None

Related works:
Journal Article: Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle? (2006)
Working Paper: Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle? (2004)
Working Paper: Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle? (2003)
Working Paper: Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle? (2003)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:szg:worpap:0302

Ordering information: This working paper can be ordered from
Studienzentrum Gerzensee, Postfach 21, 3115 Gerzensee

The price is Free.

Access Statistics for this paper

More papers in Working Papers from Swiss National Bank, Study Center Gerzensee Studienzentrum Gerzensee, Postfach 21, 3115 Gerzensee.
Bibliographic data for series maintained by library ().