Handbook of Exchange Rates

13.6 Conclusion

In this chapter, we have reviewed the implications of various forms of incomplete information in an otherwise standard model of exchange rate determination. Deviations from the complete information paradigm allow us to explain various exchange rate puzzles, such as the disconnect between exchange rates and fundamentals and the forward premium puzzle.

The focus of this chapter is mainly influenced by our previous research and does not represent an exhaustive review of the existing literature. While we have examined incomplete information in versions of the standard monetary model, some papers have examined this issue in alternative models. For example, Roberts (1995) assumes imperfect information on the persistence of a shock in a dynamic Mundell–Fleming model. However, a reduced form approach is more difficult to interpret as learning is not based on optimal inference. Martinez-García (2010) introduced imperfect information in a DSGE model. He showed that consumption reacts less to shocks. This can explain that relative consumption is less volatile than exchange rates, that is, the well-known Backus–Smith puzzle.

We have also restricted our discussion to rational expectations frameworks. An entirely different direction is to consider deviations from rational expectations, where expectations are typically based on rules that ignore all or part of the information from the model. In particular, models of adaptive learning have been applied to exchange rates in many ...