Exchange rate speculation and heterogeneous expectations in a small open economy

Abstract

We consider a standard macroeconomic model of a small open economy in which the flow of capital on the international foreign exchange market crucially depends on the expected exchange rate. These expectations about the exchange rate are modelled to be either homogeneous or heterogeneous, i.e., all agents may form naïve expectations, or they may switch between different simple linear extrapolative or regressive predictors with respect to changing market circumstances. Using a mixture of analytical and numerical tools, we attempt to describe the characteristics of our model’s dynamical systems we obtain with these different assumptions and analyse the impact of exchange rate expectations on short-term business cycle fluctuations. Our results suggest that fluctuations in both national income and the exchange rate are crucially driven by speculators’ expectations. With respect to these expectations, our numerical results additionally show an ambiguous effect of extrapolative expectations on stability. Due to coexisting attractors, an increase in the strength of extrapolative expectations may have both a destabilising and a stabilising impact on dynamics. In contrast, regressive expectations have a stabilising effect on the business cycle.