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Exchange Rate Dynamics and Learning

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  • Pierre-Olivier Gourinchas
  • Aaron Tornell

Abstract

Interest rate expectations are essential for exchange rate determination. Using a unique Survey data set on interest rate forecasts from 1986 to 1995 for G7 countries, we find that interest rate shocks were significantly more persistent in sample than expected by the market. This is consistent with ff3's finding that changes in the forward rate reflect changes in exchange rate expectations. We then present a model of nominal exchange rate determination that rationalizes the forward discount puzzle and exhibits the delayed overshooting pattern found by ee: following a monetary expansion that reduces the domestic interest rate, there is a gradual depreciation of the exchange rate followed by a gradual appreciation several months later. Delayed overshooting results from (a) the interaction of learning about the current state of affairs, and the intrinsic dynamic response of interest rates to monetary shocks and (b) the discrepancy between the actual distribution of shocks in sample and its expectation by market participants. This discrepancy is consistent with rational expectations if either (a) there is a small sample or Peso problem or (b) the true structure of the economy evolves over time and agents are learning with some delay.
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Suggested Citation

  • Pierre-Olivier Gourinchas & Aaron Tornell, 1996. "Exchange Rate Dynamics and Learning," Harvard Institute of Economic Research Working Papers 1771, Harvard - Institute of Economic Research.
    • Handle: RePEc:fth:harver:1771
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    References listed on IDEAS

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    1. Martin Eichenbaum & Charles L. Evans, 1995. "Some Empirical Evidence on the Effects of Shocks to Monetary Policy on Exchange Rates," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 110(4), pages 975-1009.
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    Cited by:

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    2. Scholl, Almuth & Uhlig, Harald, 2008. "New evidence on the puzzles: Results from agnostic identification on monetary policy and exchange rates," Journal of International Economics, Elsevier, vol. 76(1), pages 1-13, September.
    3. Arnulfo Rodriguez & Pedro N. Rodriguez, 2006. "Recursive Thick Modeling and the Choice of Monetary Policy in Mexico," Computing in Economics and Finance 2006 30, Society for Computational Economics.
    4. Faust, Jon & Rogers, John H., 2003. "Monetary policy's role in exchange rate behavior," Journal of Monetary Economics, Elsevier, vol. 50(7), pages 1403-1424, October.
    5. Aaron Tornell, 2003. "Robust-H_infinity Forecasting and Asset Pricing Anomalies (December 2001)," UCLA Economics Online Papers 237, UCLA Department of Economics.
    6. Leduc, Sylvain, 2002. "Incomplete markets, borrowing constraints, and the foreign exchange risk premium," Journal of International Money and Finance, Elsevier, vol. 21(7), pages 957-980, December.
    7. Øyvind Eitrheim & Jan Fredrik Qvigstad, 2024. "Norway’s Road to Inflation Targeting: Overcoming the Fear of Floating," Comparative Economic Studies, Palgrave Macmillan;Association for Comparative Economic Studies, vol. 66(3), pages 482-534, September.
    8. Rodríguez Arnulfo & Rodríguez Pedro N., 2007. "Recursive Thick Modeling and the Choice of Monetary Policy in Mexico," Working Papers 2007-04, Banco de México.
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