Animal spirits in the foreign exchange market Paul De Grauwe, Pablo Rovira Kaltwasser n Center of Economic Studies, Department of Economics, University of Leuven, Naamsestraat 69, 3000 Leuven, Belgium article info Article history: Received 15 February 2011 Received in revised form 9 January 2012 Accepted 9 January 2012 JEL classification: F31 C62 Keywords: Foreign exchange market Behavioral finance Uncertainty about fundamentals abstract It is traditionally assumed in finance models that the fundamental value of an asset is known with certainty. In this paper we depart from that assumption. We propose a simple model of the exchange rate in which agents have biased and unbiased beliefs about the fundamental rate. We show that such a model produces waves of optimism and pessimism unrelated to the underlying fundamental value. In addition, the model shows that in a world characterized by the existence of heterogeneous beliefs about the fundamental, exchange rate movements can be remarkably complex even if only fundamentalist traders operate in the market. & 2012 Elsevier B.V. All rights reserved. 1. Introduction Beliefs are important forces, not only in everyday life, but also in financial markets. Changes in beliefs shape events even if there is no change in the objective forces affecting reality. Economists have long recognized this in the past. Keynes (1964), for example, wrote about ‘animal spirits’ influencing reality and creating waves of optimism and pessimism. More recently, Kindelberger (2005) in his celebrated study ‘Manias, panics and crashes’ analyzed the way in which agents develop beliefs and how these beliefs move stock prices. Beliefs also matter in the foreign exchange market. A few years ago two sets of beliefs emerged about the fundamental value of the U.S. dollar. The first set was represented, among others, by Obstfeld and Rogoff (2005) and Obstfeld (2005). According to this view the large current account deficits of the U.S. observed since the second half of the 1990s were unsustainable. A major decline in the value of the dollar would be the consequence of adjusting the current account balance to a sustainable level. These authors estimated that restoring the balance in U.S., European and Asian current accounts would imply a 30% depreciation of the dollar against the Euro and a 35% depreciation against a basket of Asian currencies respectively. It turned out later that these authors were right, but at that time there were also other beliefs about the fundamental value of the dollar. One was developed by Hausmann and Sturzenegger (2006). In this alternative view there did not arise a problem of sustainability. These authors detected ‘Dark Matter’ in the international financial markets, i.e. attributes present in certain assets (the U.S. dollar in this case) that could not properly be measured. Corrected for the amount of ‘dark matter’ these authors came to the conclusion that there was in fact no net foreign US debt, and thus Contents lists available at SciVerse ScienceDirect journal homepage: www.elsevier.com/locate/jedc Journal of Economic Dynamics & Control 0165-1889/$ - see front matter & 2012 Elsevier B.V. All rights reserved. http://dx.doi.org/10.1016/j.jedc.2012.03.008 n Corresponding author. E-mail addresses: paul.degrauwe@econ.kuleuven.be (P. De Grauwe), pablo.rovirakaltwasser@econ.kuleuven.be (P. Rovira Kaltwasser). Journal of Economic Dynamics & Control ] (]]]]) ]]]–]]] Please cite this article as: De Grauwe, P., Rovira Kaltwasser, P., Animal spirits in the foreign exchange market. Journal of Economic Dynamics and Control (2012), http://dx.doi.org/10.1016/j.jedc.2012.03.008