How Small Shocks and Heterogeneous Expectations Can Create Large Swings in the Exchange Rates

Torsten Sloek - University of Copenhagen and Jens Peter Sorenson - University of Chicago & University of Copenhagen

What can explain the persistence in the exchange rate movements as observed in the DEM/USD and GBP/USD exchange rates since 1987 We use a version of the Kareken-Wallace 2-country overlapping generations model to explain this empirical phenomena. The agents use adaptive learning rules to forecast the expected prices in both countries instead of having perfect foresight as in the original Kareken-Wallace model. There are constant but different speed of adjustments in the two countries, and the constant speed of adjustment combined with small shocks to the money supply in both countries create large swings in the exchange rate. This is illustrated by simulations.

Scheduled for Session 3.3 Learning