Announcement Effects on Exchange Rate Movements: Continuity as a Selection Criterion among the REEyz

The aim of this paper is to analyze the announcement e¤ects on ex-change rate movements using the basic asset pricing model, where cur-rency trade is partly determined by technical trading in the form of mov-ing averages since it is the most commonly used technique according to questionnaire surveys. Speci\u85cally, the announcement and implementa-tion of temporary as well as permanent monetary policy are analyzed, where the exchange rate model developed is summarized in a linear dif-ference equation in current exogenous fundamentals, a large number of lags of the endogenous exchange rate and time-t dating of exchange rate expectations. However, since there are a large number of rational expec-tations equilibria, continuity is proposed as a selection criterion among the equilibria, meaning that the parameter for the time-t 1 exchange rate should have the limit 0 when there is no technical trading to have an economically meaningful equilibrium. It turns out that there is a unique rational expectations equilibrium that satisfy the continuity criterion, and focusing on this equilibrium, it is shown that the exchange rate is much more sensitive to changes in money supply than when technical trading is absent in currency trade. This result is important since it sheds light on the so-called exchange rate disconnect puzzle in international \u85nance. Earlier versions of this paper has been presented at WEHIA, in Colchester, England, June 13-15, 2005, and at seminars at the Bank of Finland, HECER and RUESG. I am grateful for helpful comments given at these occasions as well as to Seppo Honkapohja for discussing the paper with me. I am also grateful to the OP Bank Group Foundation for giving me a research grant. Of course, the usual disclaimer applies. y JEL classi\u85cation: E51, E52, F31 and G12