Behavioral Financial Theory And Behavioral Research On RMB Exchange Rate

Having compared and appraised some advanced equilibrium exchange rate theory and behavioral finance theory, we find that both the literature and new empirical evidence show that exchange rates tend to be disconnected from fundamentals over substantial periods of time. The recent "microstructure approach to exchange rates" has shed some important light on this puzzle: most exchange rate volatility at short to medium horizons is related to the noisiness of the exchange rates, not be measurable macroeconomic fundamentals. This motivates a theoretical analysis of exchange rates with noise trades.Here we introduce investor heterogeneity into an otherwise standard monetary model of exchange rate determination. The implications of the model are consistent with the evidence on the relationship between exchange rates and fundamental: (1) the exchange rate is disconnected from fundamentals in the short to medium run; (2) over longer horizons, the exchange rate is primarily driven by fundamentals; (3) exchange rate changes are a weak predictor of future fundamentals. The presence of noise traders can lead to multiple equilibrium in the foreign exchange market. The entry of noise traders both create and share the risk associated with exchange rates volatility. In such circumstances, monetary policy and share the risk associated with exchange rate volatility without altering macroeconomic fundamentals. We then design a model, which includes noise traders, to analyze the determinants of RMB exchange rate and to introduce a policy to eliminate the excessive volatility.