Foreign Currency Bubbles

Abstract

This paper develops a new model for studying foreign currency exchange rate bubbles. The model constructed is a modification of the Martingale-based bubble approach of Jarrow, Protter, and Shimbo [12], [13]. This model generates some new insights into our understanding of exchange rate bubbles and it can be utilized empirically to test for their existence. The new insights are: (i) exchange rate bubbles can be negative, in contrast to asset price bubbles, (ii) exchange rate bubbles are caused by price level bubbles in either or both of the relevant countries’ currencies, and (iii) price level bubbles decrease the expected inflation rate in the domestic economy.