The Nature of Expectations in the Foreign Exchange Market: A Test of Competing Theories

Abstract

In a 1982-83 article, Paul Davidson argues that rational expectations are a poor guide to real-world economic behavior. He supports this contention with a number of points, relying especially on the argument that entrepreneurs focus on exactly the sort of activity least likely to fit the RE mold: crucial decisions. Crucial decisions, once made, may forever change the circumstances surrounding future choices. As a consequence, ergodicity is violated and rational expectations cannot hold. A related question arising from this debate is whether or not economic agents passively forecast events or actually cause them. According to Davidson, rational expectations assume the former, though a realistic analysis would suggest the latter. This last point is the focus of the current paper. The Post Keynesian approach implies that expectations guide actions, and that those actions create the real world. This dynamic process tends to change the parameters affecting future decisions in the manner discussed above. Expectations are therefore causal. The rational expectations approach posits a world in which economic agents simply react, making forecasts of events that are driven by some independent and relatively stable stochastic process. In this context, expectations do not affect the objective variable. It is the purpose of this paper to perform an empirical test of these rival views. In particular, I examine the relationship between expectations and foreign exchange rates (using the forecast surveys published by Money Market Services). In the rational expectations model, where predictions and outcomes are expected to be correlated but not causal,