SEARCH

SEARCH BY CITATION

Keywords:

  • exchange rates;
  • expectation formationprocess;
  • consistency restrictions;
  • panel data;
  • econometricmodels

ABSTRACT

We examine consistency properties of the exchange rate expectation formation process of short-run and long-run forecasts in the dollar/euro and yen/dollar market. Applying nonlinear consistency restrictions we show that in a simple expectation formation structure short-run forecasts are indeed inconsistent with long-run predictions. Moreover, we establish a ‘twist’ in the dollar/euro expectation formation process, i.e. market participants expect bandwagon effects in the short run, while they have stabilizing expectations in their long-run forecasts. Applying a panel probit analysis we find that this twisting behavior is more likely to occur in periods of excess exchange rate volatility. Copyright © 2011 John Wiley & Sons, Ltd.