Research Discussion Papers, Bank of Finland
No 6/2006:
Announcement effects on exchange rate movements: continuity as a selection criterion among the REE
Mikael Bask ()
Abstract: The aim of this paper is to analyse the announcement
effects on exchange rate movements using the basic asset pricing model,
where currency trade is partly determined by technical trading in the form
of moving averages since it is the most commonly used technique according
to questionnaire surveys. Specifically, the announcement and implementation
of temporary as well as permanent monetary policy are analysed, where the
exchange rate model developed is summarised in a linear difference equation
in current exoge-nous fundamentals, a large number of lags of the
endogenous exchange rate and time-t dating of exchange rate expectations.
However, since there are a large number of rational expectations
equilibria, continuity is proposed as a selection criterion among the
equilibria, meaning that the parameter for the time-t – 1 ex-change rate
should have the limit 0 when there is no technical trading to have an
economically meaning-ful equilibrium. It turns out that there is a unique
rational expectations equilibrium that satisfy the conti-nuity criterion,
and focusing on this equilibrium, it is shown that the exchange rate is
much more sensitive to changes in money supply than when technical trading
is absent in currency trade. This result is impor-tant since it sheds light
on the so-called exchange rate disconnect puzzle in international
finance.
Keywords: asset pricing; exchange rate disconnect puzzle; heterogeneous agents; least squares learnability; monetary policy and technical trading; (follow links to similar papers)
JEL-Codes: E51; E52; F31; G12; (follow links to similar papers)
47 pages, June 7, 2006
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