Chartists, Fundamentalists and the Demand for Dollars

Abstract

The careening path of the dollar in recent years has shattered more than historical records and the financial health of some speculators. It has also helped to shatter faith in economists' models of the determination of exchange rates.

We have understood for some time that under conditions of high international capital mobility, currency values will move sharply and unexpectedly in response to new information. Even so, actual movements of exchange rates have been puzzling in two major respects. First, the proportion of exchange rate changes that we are able to predict seems to be, not just low, but zero. According to rational expectations theory we should be able to use our models to predict that proportion of exchange rate changes that is correctly predicted by exchange market participants. Yet neither models based on economic fundamentals, nor simple time series models, nor the forecasts of market participants as reflected in the forward discount or in survey data, seem able to predict better than the lagged spot rate. Second the proportion of exchange rate movements that can be explained even after the fact, using contemporaneous macroeconomic variables, is disturbingly low.