Announcement effects on exchange rate movements : continuity as a selection criterion among the REE

Abstract

The aim of this paper is to analyse the announcement effects on exchange rate movements using the basic asset pricing model, where currency trade is partly determined by technical trading in the form of moving averages since it is the most commonly used technique according to questionnaire surveys.Specifically, the announcement and implementation of temporary as well as permanent monetary policy are analysed, where the exchange rate model developed is summarised in a linear difference equation in current exogenous fundamentals, a large number of lags of the endogenous exchange rate and time-t dating of exchange rate expectations. However, since there are a large number of rational expectations equilibria, continuity is proposed as a selection criterion among the equilibria, meaning that the parameter for the time-t - 1 exchange rate should have the limit 0 when there is no technical trading to have an economically meaningful equilibrium.It turns out that there is a unique rational expectations equilibrium that satisfy the continuity criterion, and focusing on this equilibrium, it is shown that the exchange rate is much more sensitive to changes in money supply than when technical trading is absent in currency trade.This result is important since it sheds light on the so-called exchange rate disconnect puzzle in international finance.Key words: asset pricing, exchange rate disconnect puzzle, heterogeneous agents, least squares learnability, monetary policy and technical trading. JEL classification numbers: E51, E52, F31, G12