Exchange Rate Dynamics and Learning

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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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