Heterogeneous Agents and Non-Normal Fundamentals

Abstract

This paper proposes an explanation for the disconnect puzzle between exchange rates and macro-economic variables in variance and extremes. We insert a fundamental rate with financial market characteristics into a heterogeneous agents model and simulate exchange rates in order to examine whether the model replicates the disconnect puzzle in higher moments. The simulations are consistent with reality if the exchange rate is detached from the fundamental rate, i.e. if there is a bubble. This implies that the disconnect puzzle can be explained by the fact that the market is in a constant bubble state, caused by a high proportion of technical analysts active in the market.

Keywords: Exchange rate, Heterogeneous agents, Transmission of news, Dynamics

JEL Classification: E44, F31