An Essay on Exchange Rate Dynamics

Abstract

There is rarely another field in economics where the prevailing theoretical models have been contradicted so strongly by empirical evidence as exchange rate economics. This study therefore attempts to investigate exchange rate dynamics in an exploratory way. It is first demonstrated that the exchange rate does not follow a random walk as often postulated. There exists a systematic pattern in the process of exchange rate determination which at the same time does not conform to economic theory. In order to detect this pattern, the gestalt of exchange rate fluctuations is carefully explored. It is shown that a sequence of upward or downward price runs interrupted by some erratic fluctuations is most typical for exchange rate dynamics in the short run. Since such a pattern can be systematically exploited by certain trading rules, the importance of analysis for the expectations formation and consequently the determination of exchange rates is examined. It turns out that the trading rules implied by technical analysis, which are actually employed in the market, have systematically produced extra profits over the whole period without any relevant risk. The second part of the study focuses on the medium-term fluctuations in exchange rate dynamics. It is argued that these fluctuations can be explained as the result of interacting diseuilibria in the goods market and the asset market wherein the exchange rate fluctuates around the purchasing power parity as its center of gravity without any tendency of convergence, i.e., towards a stable equilibrium. The study concludes with a discussion on the theoretical founedations of exchange rate instability.