The behaviour of the dollar exchange rates in recent years has been perplexing in many ways. Not only has it turned out to be almost impossible to predict the movements of the dollar, more importantly, the link between the dollar exchange rates and `fundamental' variables (the money stock, interest rates, the business cycle, etc.) has been very tenuous. In Discussion Paper No. 1073, Research Fellow Paul de Grauwe attempts to explain this puzzling phenomenon of the weak link between exchange rates and fundamental variables.

The author shows that some of the puzzles observed in the foreign exchange market are a natural outcome of chaotic dynamics. Relatively simple models are capable of generating exchange rate movements that, at least in the short-run, are largely disconnected from their fundamental values. The essential ingredient of such models is the hypothesis that economic agents use different information sets. It is assumed that there are two classes of agents, fundamentalists and chartists. The former use the information contained in the model and a forecast of future fundamental variables. The latter forecast the future exchange rate based on past exchange rate movements. The interaction of these two classes of agents creates a non-linearity in the model and is responsible for the complex behaviour of the exchange rate.

Exchange Rates in Search of Fundamental Variables
Paul de Grauwe

Discussion Paper No. 1073, December 1994 (IM)