On the Unstable Relationship Between ExchangeRates and Macroeconomic Fundamentals

It is well known from anecdotal, survey and econometric evidence that the relationshipbetween the exchange rate and macro fundamentals is highly unstable. Thiscould be explained when structural parameters are known and very volatile, neitherof which seems plausible. Instead we argue that large and frequent variationsin the relationship between the exchange rate and macro fundamentals naturallydevelop when structural parameters in the economy are unknown and change veryslowly. We show that the reduced form relationship between exchange rates andfundamentals is driven not by the structural parameters themselves, but rather byexpectations of these parameters. These expectations can be highly unstable as aresult of perfectly rational \scapegoat" eects.[...]