A Behavioral Finance Model of the Exchange Rate with Many Forecasting Rules

36 Pages Posted: 5 Dec 2006

See all articles by Paul De Grauwe

Paul De Grauwe

CESifo (Center for Economic Studies and Ifo Institute for Economic Research); London School of Economics & Political Science (LSE); Centre for Economic Policy Research (CEPR)

Pablo Rovira Kaltwasser

Catholic University of Leuven (KUL); National Bank of Belgium

Date Written: November 2006

Abstract

This paper presents a behavioral finance model of the exchange rate. Agents forecast the exchange rate by means of very simple rules. They can choose between three groups of forecasting rules: fundamentalist, extrapolative and momentum rules. Agents using a fundamentalist rule are not able to observe the true value of the fundamental exchange and therefore have to rely on an estimate of this variable to make a forecast. Based on simulation analysis we find that two types of equilibria exist, a fundamental and a non-fundamental one. Both the probability of finding a particular type of equilibrium and the probability of switching between different types of equilibria depend on the number of rules available to agents. Furthermore, we find that the exchange rate dynamics is sensitive to initial conditions and to the risk perception about the underlying fundamental. Both results are dependent on the number of forecasting rules.

JEL Classification: F31, C53

Suggested Citation

De Grauwe, Paul and De Grauwe, Paul and Rovira Kaltwasser, Pablo and Rovira Kaltwasser, Pablo, A Behavioral Finance Model of the Exchange Rate with Many Forecasting Rules (November 2006). CESifo Working Paper No. 1849, Available at SSRN: https://ssrn.com/abstract=949420 or http://dx.doi.org/10.2139/ssrn.949420

Paul De Grauwe (Contact Author)

CESifo (Center for Economic Studies and Ifo Institute for Economic Research)

Poschinger Str. 5
Munich, DE-81679
Germany

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Pablo Rovira Kaltwasser

National Bank of Belgium ( email )

Brussels, B-1000
Belgium

Catholic University of Leuven (KUL) ( email )

Naamsestraat 69
Leuven, 3000
Belgium

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