Exchange rates and fundamentals under adaptive learning

This paper studies a monetary model that is standard in all respects except that market participants have incomplete knowledge about the economic structure and employ adaptive learning rules to learn about the economic environment. Market participants also must contend with unannounced regime shifts. Simulation results suggest that the models under adaptive learning, especially constant-gain learning combined with a structural change, dominate the alternative specifications of expectations in their ability to account for why fundamentals predict exchange-rate returns over long horizons but not over short horizons, and for generating excessively volatile returns and persistent deviations of the exchange rate from the monetary fundamentals. & 2008 Published by Elsevier B.V.