Article | Journal of International Money and Finance | December 1989

On the Consistency of Short-Run and Long-Run Exchange Rate Expectations

by K. A. Froot and T. Ito

Abstract

This paper examines whether short-term exchange rate expectations 'overreact' by comparing them with long-term expectations. We develop a set of nonlinear restrictions linking expectations at different forecast horizons. The restrictions impose consistency, a property weaker than rationality. We use exchange rate survey data to measure expectations and then test whether consistency holds. The data show that a current, positive exchange rate shock leads investors to expect a higher long-run future spot rate when iterating forward their short-term expectations than when thinking directly about the long run. In this sense short-horizon expectations may overreact to current exchange rate changes.

Keywords: Currencies; Exchange rates; International macroeconomics; monetary policy; Currency controls; Fixed exchange rates; Floating exchange rates; Currency bands; Currency zones; Curency areas; rational expectations; Asset Pricing;

Citation:

Froot, K. A., and T. Ito. "On the Consistency of Short-Run and Long-Run Exchange Rate Expectations." Journal of International Money and Finance 8, no. 4 (December 1989): 487–510. (Revised from NBER Working Paper No. 2577, May 1988.)