Expectations and Niehans’ exchange rate dynamics

Abstract

Jurg Niehans in his 1977 article on exchange rate dynamics had Professor this to say about the state of exchange rate expectations in his model: "Problems of expectation formation are side stepped by the radical assumption that . . . e (logarithm of expected exchange rate) is equal to the corresponding equilibrium rate and that the speed with which the actual rate is expected to approach the equilibrium rate does not matter. This clearly leaves much room for greater realism" (p. 1247) ]. This note is an attempt to build an expectation rationale into the above framework and thus to provide a sounder theoretical base to Niehans' work. The foundation used is that of rational expectations. According to this, expectations in exchange rates will be assumed to apply iteratively, being themselves derived from adaptive-regressive expectations in money supply. However, the above will generate some contrasting results in exchange rate expectations. It will be shown (Section II) that whereas expectations in money supply can be adaptive and regressive, those, by contrast, will lead respectively to regressive and adaptive expectations in exchange rates. In addition, the vehicles through which these effects occur will differ. These are growth in and level of exchange rates as compared to level of and growth in money supply respectively. The general outcome of this extension (Section III) is very interesting. All but one of Niehans' stable dynamic results will be found to survive. The one that is the exception to the rule2 obviously implies that equilibrium exchange