Business Intelligence

Heterogeneous Expectations And Exchange Rate Dynamics

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Executive Summary

This paper presents a continuous-time model of exchange rates relying not only on macroeconomic factors but also having a market microstructure component. The driving macroeconomic factor is the interest rate differential, while the market microstructure element is described by the expectations of boundedly rational portfolio managers who use a weighted average of the expectations of fundamentalists and chartists. Within this framework, the different roles of the macroeconomic factors and market microstructure elements on the determination of the exchange rate are examined explicitly. The authors show that this simple model generates very complicated market behaviour, including the existence of multiple steady state equilibria, the deviations of the market exchange rate from the fundamental, and market fluctuations.

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