Theoretical and Empirical Analysis of Consistency in the Exchange Rate Expeda1ion Formation Process

Theoretical and Empirical Analysis of Consistency in the Exchange Rate Expeda1ion Formation Process

This paper undertakes a two step test of consistency in the foreign exchange rate expectation formation process. In step one the General Extrapolative Model (GEM) is used with level of exchange rate survey forecasts. In step two the changes in levels of exchange forecasts are used to test consistency applying the cointegration methodology, thus taking non-stationarity into account. The thorny issue of the risk premium is avoided by using survey data on actual experts expectations. The GEM upholds (rejects) consistency in the short (long) forecast horizon, but the cointegration results confirm consistency and hence rationality in expectation formation across all horizons.