Are exchange rate expectations adaptive? Evidence from a structural open economy macro model

Although the assumption of rational expectations in open economy macroeconomic modeling has become standard. practice in the last two decades, recent studies have shown that adaptive rather than rational expectations may be a better representation of exchange rate expectations. We use full-information, simultaneous-equation models for G-7 countries to compare static and adaptive expectations and examine if adaptive expectations are regressive or extrapolative. While we find adaptive expectations to be regressive, static expectations cannot be rejected in favor of adaptive expectations for four and five of the seven countries at the levels of significance of 5% and 1% respectively.