Alternative Expectations Models and Exchange Rate Dynamics

This paper reconsiders the issue of exchange rate dynamics in light of recent empirical evidence on the possible failure of rational exchange rate expectations. The Dornbusch model is respecified using three popular models of exchange rate expectations tested by Frankel and Froot. A key result of the paper is that with adaptive or distributed lag expectations the exchange rate may either overshoot or undershoot in response to monetary expansion. In addition, if expectations are regressive, and asset holders base their perceptions of the long-run equilibrium exchange rate on a simple purchasing power parity calculation, either overshooting or undershooting may occur. (C) 1998 John Wiley & Sons, Ltd.