DP2575 | Exchange Rates in Search of Fundamentals: The Case of the Euro-Dollar Rate


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The decline of the euro against the dollar during 1999-2000 was mostly unrelated to observable news about the underlying fundamentals. This corroborates a general finding from the empirical literature testing the traditional exchange rate models, i.e. that exchange rate movements are disconnected from the underlying fundamentals. We formulate an hypothesis allowing us to understand this phenomenon. The core of this hypothesis is that movements in the exchange rates ?anchor? agents? beliefs and lead them to search for fundamentals that will justify these beliefs. We also analyse the implications of this view for the transmission of monetary shocks.