Essays in Memory of Albert Ando
Edited by Lawrence R. Klein
Chapter 13: Rationality, Behavior and Switching Idiosyncracies in the Euro–Dollar Exchange Rate
13. Rationality, behavior and switching idiosyncracies in the euro–dollar exchange rate Gabriella Cagliesi and Massimo Tivegna 1. INTRODUCTION: THE NEWS APPROACH AND BEHAVIORAL FINANCE The time proﬁle of the euro-dollar (€–$) exchange rate has a U-shaped form (see Figure 13.1). This exchange rate is the youngest among the major pairs and its initial values have been the object of an extensive negotiation among the participating countries1 so it must be assumed it was close to some form of ‘equilibrium’: at 1.17 on 4 January 1999. At its lowest this exchange rate was at 0.82; in the last part of 2004 the rate was above 1.3000. Values so far apart point to a persistence of misalignment vis-à-vis the dollar for long periods. This is not big news in today’s currency market. The theory of exchange rate determination has accordingly been looking, in recent times, for novel explanations of the ﬂuctuations in exchange rates. The dynamics of these variables was traditionally investigated in the 1970s and 1980s in terms of equilibrium relationships between the exchange rate and a group of macroeconomic variables, called ‘fundamentals’ (economic activity variables, inﬂation, interest rates, monetary and ﬁnancial aggregates, etc.). The appearance in the 1980s of the paper by Meese and Rogoﬀ (1983) casting serious doubts on the forecasting performance of this class of models generated a parallel reconsideration of equilibrium schemes in favor – among other schemes – of news models. In this latter approach it is the surprise in the fundamentals (the ‘news’) moving...
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