Is there a peso problem? Evidence from the dollar/pound exchange rate, 1976-1987

Abstract

One of the most puzzling aspects of the floating-exchange-rate regime since 1973 has been the apparent irrationality embedded in investors' exchange-rate expectations. This paper investigates whether exchange-rate forecasts, although biased, are still rational. The idea is that investors can be rational and yet make repeated mistakes if the true model of the exchange rate is evolving over time. The author's results support the hypothesis that the exchange rate has followed a switching-regime process. Moreover, the switching-regime model estimated can explain about 75 percent of the bias implied by the forward market and the survey data. Copyright 1993 by American Economic Association.

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