Fundamentals uncertainty, bubbles, and exchange rate dynamics

Abstract

Using a monetary model of exchange rate determination, we study exchange rate dynamics with bubbles which depend on stochastic market fundamentals. These dynamics can be either stochastically stable or unstable; and either monotonic or non-monotonic (including cyclic). In an extreme case, they converge with probability one and exhibit cyclic movements. Implications for the analysis of time-dependent regime shifts are also explored. Exchange rates with bubbles are likely to appear less volatile than the fundamentals in finite samples. Both the variance bounds and cointegration tests might thus be ineffective in testing the absence of bubbles under fundamentals uncertainty.