DP3725 Exchange Rate Dynamics, Learning and Misperception

Author(s):	Pierre-Olivier Gourinchas, Aaron Tornell
Publication Date:	January 2003
Keyword(s):	delayed overshooting, forward premium puzzle, monetary policy, predictable returns
JEL(s):	E40, F31, G10
Programme Areas:	International Macroeconomics
Link to this Page:	cepr.org/active/publications/discussion_papers/dp.php?dpno=3725

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.