Rational Expectations and the Volatility of Floating Exchange Rates

One popular criticism of rational expectations models of exchange rate determination is that recent movements in exchange rates have been too volatile to be justified by movements in ''fundamental'' economic conditions. An effort is made to formally derive the implications of a broad class of rational expectations models for the volatility of exchange rates, with particular emphasis on the importance of magnification and overshooting effects. For the monetary models considered by previous researchers, it is demonstrated that a magnification effect is possible when the exogenous processes are nonstationary. Monetary models in which the first differences of the exogenous variables are stationary were found to restrict the volatility of changes in the exchange rate. Results suggest that very complicated patterns of exchange rate behavior are potentially explainable in the context of a sufficiently rich rational expectations model with covariance stationary variables.