Exchange rate and price dynamics under adaptive and rational expectations: An empirical analysis

Abstract

While the concept of rational expectations has become a central tenant of open economy macroeconomic modeling, Frankel and Froot (1990a), using survey data, find that exchange rate expectations are either extrapolative or regressive. We estimate structural and semi-structural open economy macroeconomic models, with static, adaptive, and rational expectations, to empirically investigate these questions. The two major results of the paper are first, that the restrictions imposed by static expectations are overwhelmingly rejected in favor of either adaptive or rational expectations, and second, that it is not possible to choose empirically between rational and adaptive expectations. (JEL F31).