Exchange Rate Dynamics with Chartists, Fundamentalists, and Rational Speculators in the Foreign Exchange Market

Abstract

This paper extends previous work on speculative dynamics in the foreign exchange market. The analysis shows how the behavior of chartists, fundamentalists, and rational speculators, together with uncertainty about the long-run equilibrium exchange rate level, can result in fluctuations of the spot rate triggered by a random shock to the market. Although the exact exchange rate path depends on the extent of the shock and on specific values of model parameters, the heterogeneity of expectations can explain several characteristics of short term exchange rate developments, which have often been emphasized in empirical studies on exchange rate dynamics. I. INTRODUCTION According to a famous saying in economics, no theory has ever been overthrown by empirical studies. Several approaches in exchange rate economics seem to be examples of this observation. In fact, the variety of approaches trying to explain exchange rate movements is much higher than in most areas of economic theory. While traditional approaches emphasize the importance of the influence of macroeconomic fundamentals on exchange rates and use the rational expectation hypothesis, many alternative views have been presented in the literature since the mid-1980s. Triggered by the poor prediction quality of

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