Technical Trading And The Volatility Of Exchange Rates

The microeconomic structure of foreign exchange markets can cause excessive volatility in flexible exchange rate regimes. The market entry of chartists changes the composition of the foreign exchange market and leads to excessive volatility. Our chartist model predicts a continuum of equilibria and an U-shaped relation between exchange rate volatility and the measured trend, which is supported by the empirical evidence. The data show a positive nonlinear relation between trend and volatility, as predicted by the model. In such a situation monetary policy may be able to smooth the exchange rate without changing macroeconomic fundamentals.