The Dollar-Euro Exchange Rate and the Limits of Knowledge
By Roman Frydman and Michael D. Goldberg
1 Introduction
In the very beginning of the new European currency, the Dollar seemed to be overvalued, and then the Euro started not only to catch up, but skyrocketed to a 30% overvaluation, according to PPP.
Given this extraordinary rally, it is legitimate to wonder what the future evolution will be. Unfortunately it is impossible to foresee the behaviour of the exchange rate using macroeconomic fundamentals as they are the very same that led to the current situation; some studies otherwise attribute the path of the currencies to market irrationality, making it impossible to be described with in a model; moreover, practitioners and journalists often use macroeconomic fundamental when they have to justify exchange rates movements.
2 Lost Fundamentals in Contemporary Economic Models
This section inquires the methodology of forecasting under the assumption of the limits of human knowledge, which are the very cause of the unpredictability of some events. They call this approach “Imperfect Knowledge Economics”, IKE.
Agents in the financial markets are able to see the dynamic relation that ties exchange rate to macroeconomic fundamentals, but due to limited knowledge, it is impossible to implement that intuition into an econometric model, in other words, to obtain forecasts.
For the very same reason, a model that includes only systematic information and that exclude any change in fundamentals, is completely useless because it is no more than a descriptive tool. When such a model is used for forecasting, the results are not better than naïve model ones, i.e. tossing a coin.
3 Understanding Markets in Capitalist Economies
There is not a unique strategy that agents set in financial market to forecast exchange rates and to face them. This statement implies that the final behaviour of the currency is lead by a number of rational and irrational factors, by both quantitative and qualitative measures.
Under the IKE paradigm, they build a model that can predict exchange rates behaviour exploiting the qualitative regularities that financial markets show.
4 and 5 The Near and Longer Term Outlook for the Dollar-Euro Exchange Rate
IKE model is an alternative to both rational expectation and behavioural models; it is based on the assumption that the agents do not share the same model, allowing for different forecasts. Decisions are based upon macroeconomic fundamentals and revisions of previous results and assumptions. Revisions are purely random, so they can not be foreseen. When a persisting trend in fundamentals is combined with a low inclination in revising forecasts, then deviations from PPP appear.
In terms of the current Dollar-Euro exchange rate issue, then, we shall see convergence toward PPP when there is a change in conservative revisions or in macro trends.
In the long term, the exchange rate reverts towards PPP. Even if significant deviation may occur sometimes, they are bounded: at certain level bulls in the market will be so concerned about a reversal, that it will occur. We can not say if the exchange rate will stay still at its PPP level or shoot in the opposite direction as happened to the Dollar-Euro ratio.
6 A New Policy Proposal for Limiting the Magnitude of Exchange Rate Swings
The authors’ proposal implies a sort of exchange rate targeting, where the central bank declares its objectives in terms of parity values every month, to stabilize markets and avoid large swings.
http://www.earthinstitute.columbia.edu/ccs/documents/IKE%20of%20Dollar-Euro%20Exchange%20Rate%20RF_MDG%2011_7_2007_CCS.pdf
