Working Paper

Rationality and the Meese and Rogoff Exchange-Rate-Disconnect Puzzle: Learning vs. Contingent Knowledge

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There is much anecdotal evidence in the popular media, backed up by survey research, that participants in currency markets pay close attention to fundamental economic variables in forming their forecasts of future exchange rates.

It is obvious, for example, that market participants hang on every word that central bank officials utter, attuned to the slightest hint of a change in monetary policy. Similarly, in the aftermath of the global financial crisis that began in 2008, market participants saw the US dollar as a safe haven, and watched for any news that might indicate whether the crisis was deepening or dissipating.

Because participants’ forecasts drive their behavior in currency (and other financial) markets, we would expect fundamental variables to have considerable influence on exchange-rate fluctuations. And yet, over the past three decades, empirical re- searchers, operating with models that rely on the rational expectations hypothesis (REH), have uncovered little formal evidence that fundamentals matter for exchange- rate movements.