Exchange rate fluctuations in an economy with noise traders

This paper analyzes the stability of the exchange rate in an economy with noise traders. Noise trading is restricted to agents investing in the domestic stock market. The agents pricing foreign exchange hold rational expectations. Monetary policy is affected by the behavior of investors in the domestic stock market and in turn affects fundamental stock evaluations as well as noise trading. We show that when monetary policy affects only fundamentalists bifurcation appears in the exchange rate. When monetary policy also affects noise trading, fixing the exchange rate or switching to a low money growth rule imply stock bubbles converge to zero. (C) 2003 Published by Elsevier Inc.