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Handbook of Exchange Rates by Lucio Sarno, Ian Marsh, Jessica James

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4.1 Introduction

4.1.1 Mainstream Exchange Rate Models

Ever since the breakdown of the Bretton Woods system in the early 1970s, exchange rate economics became a popular field in economic research. The start of the era of floating exchange rates opened a niche not only for economists but also for policy makers to experiment with new rules, and for financial market practitioners to deal, and ideally make some profits, in the foreign exchange market.

The beginning of the 1970s also coincides with the rapid propagation of the new paradigm of rational expectations (RE) in macroeconomic and finance modeling. Not surprisingly, exchange rate models have been strongly influenced by this intellectual framework, such that as of today the majority of the exchange rate models are based on RE. RE models offer several appealing advantages compared to previous economic theories. Most importantly, they allow the introduction of micro foundations in economic modeling, which means that decisions made at the individual level are based on optimal forecasts using all available information. As a consequence, in these models, individuals never make systematic mistakes (Sargent and Wallace, 1973; Sargent, 1979; Galí, 2008).

Despite the elegance and popularity of RE models, the validity of this framework has not been free of criticism. The FOREX market provides large amounts of data, and this has opened the possibility to test the validity of theoretical models using many different techniques. Far from ...

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