DP3725 Exchange Rate Dynamics, Learning and Misperception

Author(s): Pierre-Olivier Gourinchas , Aaron Tornell

Publication Date: January 2003

Keyword(s): forward premium puzzle , delayed overshooting , predictable returns , monetary policy

JEL(s): E40 , F31 , G10

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3725.asp

We propose a new explanation for the forward-premium and the delayed-overshooting puzzles. Both puzzles arise from a systematic under-reaction of short-term interest rate forecasts to current innovations. Accordingly, the forward premium is always a biased predictor of future depreciation; the bias can be so severe as to lead to negative coefficients in the ‘Fama’ regression; delayed overshooting may or may not occur depending upon the persistence of interest rate innovations and the degree of under-reaction; lastly, for G-7 countries against the US, these puzzles can be rationalized for values of the model's parameters that match empirical estimates.