Discussion paper
DP20321 Individual Beliefs, Demand for Currency, and Exchange Rate Dynamics
In this paper, we build a general equilibrium model that takes the institutional details of the foreign exchange market into account and allows for deviations from full information rational expectations (FIRE) in a way consistent with forecast survey data and traders’ asset positions. We show that the testable implications of this model—related to foreign exchange derivatives positions, and both realized and expected exchange rates—are strongly supported in the data. Moreover, we argue that the particular form of deviation from FIRE implied by the data can help resolve important exchange rate puzzles, such as the Fama puzzle and the delayed overshooting puzzle, and can generate hump-shaped dynamics of exchange rates.
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