Heterogeneous expectations and exchange rate dynamics

This article presents a continuous-time model of exchange rates not only relying on macroeconomic factors but also having an investor heterogeneity component. The driving macroeconomic factor is the domestic-foreign interest rate differential, while the investor heterogeneity is described by the expectations of boundedly rational portfolio managers who use a weighted average of the expectations of fundamentalists and chartists. Within this framework, the different roles of the macroeconomic factor and investor heterogeneity in the determination of the exchange rate are examined explicitly. We show that this simple model generates very complicated market behaviour, including the existence of multiple steady-state equilibria, deviations of the market exchange rate from the fundamental one and market fluctuations. Numerical simulation of the corresponding stochastic version of the model shows that the model is able to generate typical time series and volatility clustering patterns observed in exchange rate markets.