Expectations and Rational Expectations in the Foreign Exchange Market

Abstract

The difficulty orthodox economists have had in finding an empirically successful exchange rate theory is well documented [see, for example, Harvey 1996a; Taylor 1995a, 1995b]. Every test of a full-scale model has yielded either a very poor fit or moderate success in an extremely limited context. One result of those failures has been the movement of empirical research away from the estimation of specific models of exchange rate determination to statistical analyses of the general characteristics of currency markets. Because this coincided with a growing realization, within mainstream economics, that international money was best understood as an asset, rational expectations (RE) has been among the most tested qualities. These developments were facilitated by the creation of several sets of data composed of surveys of currency dealers' expectations of future price movements. Unfortunately, the new studies have not yielded successful explanations. Tests of RE have found little support for the concept [Takagi 1991]. This has caused many to conclude that short-term exchange rate movements are irrational and therefore inexplicable [Harvey 1996b]. They have all but abandoned attempts to explain anything but the long run [Taylor 1995b; Pentecost 19931. It is the premise of this paper that while the neoclassical characterization of foreign currency as an asset is quite right, neoclassical economists have misunderstood the specific role that expectations play. Their conception of the market assumes that

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