Psychological and Institutional Forces and the Determination of Exchange Rates

Neoclassical economists have, by their own admission, had a terrible time explaining foreign- currency prices. Not only have they been unable to develop models that explain the past time series of foreign exchange rates with any regularity but their premises lead to conclusions about the character of the market that are inconsistent with many of its salient features. Mainstream approaches cannot, for example, account for exchange rate volatility, nonrational expectations, or the popularity of technical analysis. It is my contention that neoclassicists’ failure can be traced in large part to their assumption that economic behavior is independent of social, psychological, and cultural influences and is instead driven by rational and presumably natural free market impulses. The purpose of this paper is to show that an explanation of exchange rate determination that places the activity in its psychosocial context yields results superior to those of one based on traditional neoclassical principles. In particular, it will be shown that if agents’ behavior is modeled as being a function of their socialization in the capitalist system (and subsequent molding within the subculture of portfolio investors) and if their forecasting and decision-making processes are assumed to be driven by the same factors as theorized by psychologists (rather than economists), then the picture that emerges is one wherein bandwagon effects are common, periods of volatility are to be expected, and predictions can contain persistent bias.