Anchoring and Psychological Barriers in Foreign Exchange Markets

Abstract

This paper develops a simple behavioral exchange rate model in which investor perception of the fundamental value is anchored to the nearest round number. Traders adjust their anchors in two ways. Some believe that exchange rates move toward (perceived) fundamentals, while others bet on a continuation of the current exchange rate trend. The behavior of the traders causes complex dynamics. Since the exchange rate tends to circle around its perceived fundamental value, the foreign exchange market is persistently misaligned. Central authorities have the opportunity to reduce such distortions by pushing the exchange rate to less biased anchors, but to achieve this, they have to break psychological barriers between anchors.