Fundamental and Non-Fundamental Equilibria in the Foreign Exchange Market. A Behavioural Finance Framework

De Grauwe, Paul; Dieci, Roberto; Grimaldi, Marianna

Fundamental and Non-Fundamental Equilibria in the Foreign Exchange Market. A Behavioural Finance Framework

46 Pages Posted: 24 Mar 2005

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)

Roberto Dieci

Department of Mathematics, University of Bologna

Marianna Grimaldi

Monetary Policy Division Sveriges Riksbank

Date Written: March 2005

Abstract

We develop a simple model of the exchange rate in which agents optimize their portfolio and use different forecasting rules. They check the profitability of these rules ex post and select the more profitable one. This model produces two kinds of equilibria, a fundamental and a bubble one. In a stochastic environment the model generates a complex dynamics in which bubbles and crashes occur at unpredictable moments. We contrast these "behavioural" bubbles with "rational" bubbles.

Keywords: exchange rate, bounded rationality, heterogeneous agents, bubbles and crashes, complex dynamics, basins of attraction

JEL Classification: F31, F41, G10

Suggested Citation: Suggested Citation

De Grauwe, Paul and Dieci, Roberto and Grimaldi, Marianna, Fundamental and Non-Fundamental Equilibria in the Foreign Exchange Market. A Behavioural Finance Framework (March 2005). CESifo Working Paper Series No. 1431. Available at SSRN: https://ssrn.com/abstract=692021