A Behavioral Finance Model of the Exchange Rate with Many Forecasting Rules
Paul De Grauwe
London School of Economics & Political Science (LSE); CESifo (Center for Economic Studies and Ifo Institute for Economic Research); Centre for Economic Policy Research (CEPR)
Pablo Rovira Kaltwasser
Catholic University of Leuven (KUL)
CESifo Working Paper No. 1849
This paper presents a behavioral finance model of the exchange rate. Agents forecast the exchange rate by means of very simple rules. They can choose between three groups of forecasting rules: fundamentalist, extrapolative and momentum rules. Agents using a fundamentalist rule are not able to observe the true value of the fundamental exchange and therefore have to rely on an estimate of this variable to make a forecast. Based on simulation analysis we find that two types of equilibria exist, a fundamental and a non-fundamental one. Both the probability of finding a particular type of equilibrium and the probability of switching between different types of equilibria depend on the number of rules available to agents. Furthermore, we find that the exchange rate dynamics is sensitive to initial conditions and to the risk perception about the underlying fundamental. Both results are dependent on the number of forecasting rules.
Number of Pages in PDF File: 36
JEL Classification: F31, C53working papers series
Date posted: December 5, 2006
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