The empirical literature demonstrates that there are often large movements in exchange rates which are apparently unexplained by macroeconomic fundamentals. Frankel and Froot (1990, p. 73), for example, writes:
"[...] the proportion of exchange rate movements that can be explained even after the fact, using contemporaneous macroeconomic variables, is disturbingly low."
The purpose of this letter is to implement theoretically, the empirical observation that the relative importance of fundamental versus technical analysis in the foreign exchange market depends on the planning horizon. For shorter planning horizons, more weight is placed on technical analysis, while more weight is placed on fundamental analysis for longer planning horizons (Taylor and Allen, 1992, and Lui and Mole, 1998).
In the model developed below, the chartists use moving averages when forming their expectations since it is the most common model used (Taylor and Allen, 1992, and Lui and Mole, 1998). The fundamentalists use (a simplified version of) the Dornbusch (1976) overshooting model. The question in focus is: how is the magnitude of exchange rate overshooting affected when chartists are introduced into the Dornbusch (1976) model?
The remainder of this letter is organized as follows. The benchmark model and the expectations formations are presented in Section 2. The formal analysis of the model is carried out in Section 3, and Section 4 contains some concluding remarks.
By Mikael Bask
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Summary: Index