At a lunchtime meeting on 23 April, Paul De Grauwe presented the results of recent research on psychological barriers in currency markets. De Grauwe is Professor of Economics at the Katholieke Universiteit Leuven and a Research Fellow in CEPR's International Macroeconomics programme. His remarks were based on his CEPR Discussion Paper No. 621, `Psychological Barriers in the Foreign Exchange Market', written jointly with Danny Decupere. The views expressed by Professor De Grauwe were his own, however, and not those of CEPR, which takes no institutional policy positions.

De Grauwe noted how the financial press routinely describes the movements of major currencies' exchange rates in terms of `resistance levels' or `psychological barriers'. Exchange rates are often said to resist movement towards some rounded number such as 150 yen or 2 Deutschmarks to the dollar; but once these levels are transgressed, the exchange rate movements are held to accelerate. Certain values of exchange rates (mainly rounded numbers) therefore appear to have an important influence on the dynamics of the market. Academic economists have generally dismissed such ideas, which run counter to rationality and market efficiency. Whether an exchange rate ends with a zero or any other number should be irrelevant: otherwise, multiplying the exchange rates of an individual currency by an arbitrary constant, which makes a previously rounded number unrounded but leaves the relative prices of all other currencies unchanged, will affect the structure of demand for these currencies. This irrelevance should be even stronger in currency markets than in stock markets, because any exchange rate can also be represented by its inverse.

De Grauwe noted that psychological barriers have recently been found in the movements of stock market indices for a number of major countries and described his similar analysis for foreign exchange markets. He classified daily quotations of the dollar/DM and dollar/yen exchange rates and their inverses during 1980-90 into 100 classes according to their last two digits and tested for the presence of `unit' and `decimal' psychological barriers 1.00, 2.00, 3.00 ... and 1.100, 1.200, 1.300 ... respectively on the basis that significantly fewer daily closing prices will be observed in the neighbourhood of any such psychological barriers than elsewhere.

His results indicated that psychological barriers do exist and are significant in the dollar/yen market. This resists movements towards exchange rates of 130, 140, ... yen per dollar, etc., although they accelerate away from such barriers once crossed. In contrast, inverted quotations (say 0.5 US cents per yen) exert no such psychological effects. The evidence in the dollar/DM market is less clear-cut. There is some weak evidence that the DM 2 and DM 3 per dollar barriers exert such psychological effects; but numbers such as DM 1.4, 1.5, 1.6 ... do not; while none of the inverted quotations appear to have any psychological impact. De Grauwe also reported the results of later work indicating that such psychological barriers exist in the sterling-dollar market and elsewhere, but only in currency markets that involve the dollar.

De Grauwe concluded that these results cast doubt on the efficiency of foreign exchange markets, since irrelevant information appears to influence agents' willingness to buy and sell foreign currencies and agents apparently prefer one method of quoting exchange rates over its inverse. Defenders of the efficient market hypothesis may claim that psychological barriers do not prove the existence of exploitable profit opportunities, so the existence of psychological barriers need not contradict market efficiency. Transactions costs in foreign exchange markets are now so low, however, that the profitable exploitation of such psychological barriers should be possible. The continued existence of such barriers indicates that profit taking by rational agents is a weak force in the market.