The Scapegoat Theory of Exchange Rates: The First Tests

Abstract

This paper provides an empirical test of the scapegoat theory of exchange rates (Bacchetta and van Wincoop 2004, 2013). This theory suggests that market participants may attach excessive weight to individual economic fundamentals, which are picked as "scapegoats" to rationalize observed currency fluctuations at times when exchange rates are driven by unobservable shocks. Using novel survey data that directly measure foreign exchange scapegoats for 12 exchange rates, coupled with data on currency transactions, we find empirical evidence that strongly supports the scapegoat theory. The resulting models explain a large fraction of the variation and directional changes in exchange rates.

Keywords: scapegoat, exchange rates, economic fundamentals, survey data, order flow

JEL Classification: F31, G10