It was demonstrated in this paper that the exchange rate “overshoots the overshooting equilibrium” when chartists were introduced into a stickyprice monetary model due originally to Dornbusch (1976). Chartists were introduced since questionnaire surveys reveal that currency trade to a large extent is based on technical trading, where moving averages is the most commonly used technique. Moreover, the surveys also reveal that the importance of technical trading depends inversely on the planning horizon in currency trade.
By implementing these observations theoretically, and deriving the exchange rate’s perfect foresight path near longrun equilibrium, it was also demonstrated that the shorter the planning horizon is, the larger the magnitude of exchange rate overshooting. The effects on the exchange rate’s time path of changes in the model’s structural parameters were also derived.
To give one example of the predictions of the model developed, consider a change in the degree of stickiness of goods prices (β). According to (70), there are two effects on the magnitude of exchange rate overshooting; a direct e¤ect and an indirect effect. More flexible goods prices will increase the perfect foresight planning horizon, which in turn decreases the extent of exchange rate overshooting. This is the indirect e¤ect of a change in the structural parameter, and since there is no direct effct, the total effect of an increased flexibility of goods prices is a decrease in the magnitude of exchange rate overshooting.
Thus, if we refer to the …rst paragraph in the introductory section of this paper, a first step has been taken in developing an economic theory of exchange rate movements by taking into account observed behavior of currency traders. Of course, the present paper is not the only paper that takes this step, but in our opinion there are too few papers that use a chartistfundamentalist setup in a foreign exchange model.
Moreover, the chartists’expectations in those papers are very simple with, for example, no consideration taken for the role of the planning horizon in currency trade. Therefore, more research within this area is needed, where the chartists’ expectations are based on other technical trading techniques than moving averages, and the fundamentalists’expectations are based on other macroeconomic models than the model used in this paper.
By Mikael Bask and Carina Selander
Next: Appendix
Summary: Index