Changing Beliefs and Systematic Rational Forecast Errors with Evidence from Foreign Exchange

Recent evidence concerning dollar forecasts during the early 1980s have led to assertions that the market was irrational. This paper investigates an alternative interpretation. Following the tightening of the U.S. money market, agents did not immediately believe that the change would persist, but instead learned the shift rationally. Empirical simulations indicate that the model appears consistent with about half of the dollar's underprediction implied by the forward market during the period.