Conditions under which Exchange Rate may overshoot Even in the Research Paper

Conditions under which Exchange Rate may overshoot Even in the Presence of Rational Expectations - Research Paper Example    John F. Muth of Indiana University coined the theory of rational expectations in the early sixties. He used the term to describe economic situations under which, the outcome depends on peoples' expectations. For example, as discussed by Sargent J. Thomas (Rational Expectations) "The price of an agricultural commodity depends on how many acres farmers plants, which in turn depends on the price that farmers expect to realize when they harvest and sell their crops". The theory greatly applies to the stock markets around the world, as, if investors expect the price of common stock of a particular company to come down they go on a selling spree and the result is obvious, and when they expect it to go up they buy heavily and hence, the prices spirally. To conclude the cornerstone of the theory, we can suggest that, people behave or take decisions in order to maximize the value of an outcome and they keep getting feedback from the transactions, as to what they expected and what they ac tually received. In this way, their expectations over a period of time tend to stabilize because of the result of the past outcomes. In other words, their expectations become rational. To put the theory in mathematical perspective, let us assume that P* is the equilibrium price (a price at which demand equals supply) in a market, then according to the rational expectations theory (Pe) will be the function of P* + e, where (Pe) is the expected price and e is the random error term, which is independent of P*. (Sargent J. Thomas, Rational Expectations). The theory of rational expectations is often put into practice in many economic as well as finance models. One such execution of the model is related to The Efficient Markets Theory of Stock Prices, which states that there are three forms of the efficient-market hypothesis, namely, weak form, semi-strong form, and strong form (Fischer Donald and Jordan Ronald 540). Weak form, which is also known as the Random-walk theory suggests that there is no purpose of examining the charts as the share pieces fully reflect the historical sequences. Semi-strong form, on the other hand, suggests that current market prices not only reflect the historical chart patterns, but also reflect all the publicly available knowledge, so this kind of information is almost always useless for the analysts and the investors. The theory maintains that as soon as the information is made public, the price plays catch-up and soon starts to reflect the new announcement. Finally, strong form suggests that not only pub licly available information is useless, but also all the information concerning the company is useless, as that will have no impact over the stock price.