Chartists, Fundamentalists, and Trading in the Foreign Exchange Market

Annual Research Conference--II: Chartists, Fundamentalists, and Trading in the Foreign Exchange Market The overshooting theory of exchange rates seems ideal for explaining some important aspects of the movement of the dollar in recent years. From 1981-4, for example, when real interest rates in the United States rose above those of her trading partners (presumably because of shifts in the monetary/fiscal policy mix), the dollar appreciated strongly. This episode supported the overshooting theory: the higher rates of return had made U.S. assets more attractive to international investors, which is what caused the dollar to appreciate; the appreciation continued until the dollar's value was so far above long-run equilibrium that expectations of future depreciation were enough to offset the higher nominal interest rate in the minds of international investors. (Figure 1 shows the correlation of the real interest differential with the real value of the dollar, since exchange rates began to float in 1973.) Bubble Episodes At times, however, the path of the dollar has departed from what would be expected on the basis of macro-economic fundamentals. The most dramatic example was the period from June 1984 to February 1985. The dollar appreciated 20 percent over this interval, even though the real interest differential already had begun to fall. The other observable factors that are suggested in standard macroeconomic models--money growth rates, real growth rates, the trade deficit--also were moving in the wrong direction to explain the dollar's rise at this time. Of course, standard observable macroeconomic variables cannot explain, much less predict, most short-term changes in the exchange rate. But what does this mean? It may be that the unexplained short-term changes are rational revisions in the market's perception of the long-run equilibrium exchange rate. These revisions are caused by shifts in "tastes and technologies," even if the shifts are not observable to macroeconomists as standard measurable fundamentals. A major difficulty with this interpretation, though, is that it is hard to believe that the world demand for U.S. goods (or U.S. productivity) could have risen enough to increase the equilibrium real exchange rate by more than 20 percent over a nine-month period, let alone that such a shift then would be reversed over an equally short period. The second view is that the appreciation may have been an example of a speculative bubble: that it was unrelated to fundamentals, but rather was the outcome of self-confirming market expectations. In other words, the dollar "overshot the overshooting equilibrium. " This also may have been the nature of the dollar appreciation of 1988-9. Ken Froot and I have suggested that such episodes may be examples of speculative bubbles, and that they may be described best by models in which market participants are not necessarily assumed to agree on the correct way to forecast the exchange rate. (1) Trading Volume in the Foreign Exchange Market Supporting the idea that market participants differ widely in their forecasts is the tremendous volume of foreign exchange trading. If participants all agree on their forecasts, why do they trade so much? In April 1989, foreign exchange trading (adjusted for double-counting) in the United States totaled $128.9 billion a day, an increase of 120 percent from March 1986. Simultaneous counts in London and Tokyo reported $187 billion and $115 billion a day, respectively. Thus the worldwide total is over $430 billion of foreign exchange trading a day. Interestingly, the banks in the New York Fed Census reported that only 4.9 percent of their trading was with a nonfinancial firm; for the nonbanks, only 4.4 percent of their trading was with a nonfinancial firm. In other words, 95 percent of trading takes place among banks and other financial firms, rather than with customers (importers and exporters). …