This paper presents a model of business cycles driven by shocks to consumer expectations regarding aggregate productivity. Agents are hit by heterogeneous productivity shocks, they observe their own productivity and a noisy public signal regarding aggregate productivity. The public signal gives rise to “noise shocks, ” which have the features of aggregate demand shocks: they increase output, employment and in‡ation in the short run and have no e¤ects in the long run. The dynamics of the economy following an aggregate productivity shock are also a¤ected by the presence of imperfect information: after a positive productivity shock output adjusts gradually to its higher long-run level, and there is a temporary negative e¤ect on in‡ation and employment. Numerical results suggest that the model can generate sizeable amounts of noise-driven volatility in the short run. JEL Codes: E32, D58, D83 Keywords: information. Consumer con…dence, aggregate demand shocks, business cycles, imperfect MIT and NBER. Email: glorenzo@mit.edu. A previous version of this paper circulated under the title:

The rational expectations efficient market model of the exchange rate has failed empirically. In this paper we develop a model of the exchange rate in which agents use simple forecasting rules. Based on an ex post evaluation of the relative profitability of these rules they decide whether to switch or not. In addition, transactions costs in the goods market are introduced. We show that this simple model creates great complexity in the market, which is characterised by the fact that the exchange rate is disconnected from its fundamental most of the time. Periods of tranquillity and turbulence alternate in unpredictable manner. Finally we show that this model mimics most of the empirical puzzles uncovered in the literature.

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Many papers have argued that home bias arises because home investors can predict payoffs of their home assets more accurately than foreigners can. But why does this information advantage exist in a world where investors can learn foreign information? We model investors who are endowed with a small home information advantage. They can choose what information to learn before they invest in many risky assets. Surprisingly, even when home investors can learn what foreigners know, they choose not to. The reason is that investors profit more from knowing information that others do not know. Allowing investors to learn amplifies their initial information asymmetry. The model explains local and industry bias as well as observed patterns of foreign investments, portfolio out-performance and asset prices. Finally, we outline new avenues for empirical research.

Abstract Taylor (1994, 1995)

Abstract In a financial market where traders are risk averse and short lived, and prices are noisy, asset prices today depend on the average expectation today of tomorrow's price. Thus (iterating this relationship) the date 1 price equals the date 1 average expectation of the date 2 average expectation of the date 3 price. This will not in general equal the date 1 average expectation of the date 3 price. We show how this failure of the law of iterated expectations for average belief can help understand the role of higher order beliefs in a fully rational asset pricing model and explain over-reaction to (noisy) public information. * This is a much revised version of the paper with the longer title "Beauty Contests, Bubbles and Iterated Expectations in Asset Markets". We thank seminar participants at the LSE, the Bank of England, the IMF, Stanford, the accounting theory mini-conference at Chicago GSB, and the Gerzensee finance meetings for their comments. We thank Mehul Kamdar for capable research assistance. We are grateful to the editor, Maureen O'Hara and a referee for their guidance.

The carry trade is the investment strategy of going long in high-yield target currencies and short in low-yield funding currencies. Recently, this näıve trade has seen very high returns for long periods, followed by large crash losses after large depreciations of the target currencies. Based on low Sharpe ratios and negative skew, these trades could appear unattractive, even when diversified across many currencies. But more sophisticated conditional trading strategies exhibit more favorable payoffs. We apply novel (within economics) binary-outcome classification tests to show that our directional trading forecasts are informa-tive, and out-of-sample loss-function analysis to examine trading performance. The critical conditioning variable, we argue, is the fundamental equilibrium exchange rate (FEER). Expected returns are lower, all else equal, when the target currency is overvalued. Like traders, researchers should incorporate this information when evaluating trading strategies. When we do so, some questions are resolved: negative skewness is purged, and market volatility (VIX) is uncorrelated with returns; other puzzles remain: the

Using novel real-time data on a broad set of economic fundamentals for five major US dollar exchange rates over the recent float, we employ a predictive procedure that allows the relationship between exchange rates and fundamentals to evolve over time in a very general fashion. Our key findings are that: (i) the well-documented weak out-of-sample predictive ability of exchange rate models may be caused by poor performance of model-selection criteria, rather than lack of information content in the fundamentals; (ii) the difficulty of selecting the best predictive model is largely due to frequent shifts in the set of fundamentals driving exchange rates, reflecting swings in market expectations over time. However, the strength of the link between exchange rates and fundamentals is different across currencies.

Abstract Using data on cross-sectional dispersion in forecasters'long-and short-run predictions of macroeconomic variables, we identify key sources of disagreement. Dispersion among forecasters is highest at long horizons where private information is of limited value and lower at short forecast horizons. Moreover, di¤erences in views persist through time. Such di¤erences in opinion cannot be explained by di¤erences in information sets; our results indicate they stem from heterogeneity in priors or models. We also …nd evidence that di¤erences in opinion move countercyclically, with heterogeneity being strongest during recessions where forecasters appear to place greater weight on their prior beliefs. Keywords: Dispersion in beliefs, heterogeneous information, term structure of forecasts. J.E.L. Codes: E37, C53, C32. We thank the Editor and an anonymous referee for many constructive comments. We also thank Roy Batchelor,

This paper examines whether the traditional sets of macro surprises, that most of the literature considers, are the only sorts of news that can explain exchange rate movements. We examine the intra-daily influence of a broad set of news reports, including variables which are not typically considered “fundamentals ” in the context of standard models of exchange rate determination, and ask whether they too help predict exchange rate behavior. We also examine whether “news ” not only impacts exchange rates directly, but also influences exchange rates via order flow (signed trade volume). Our results indicate that along with the standard fundamentals, both non-fundamental news and order flow matter, suggesting that future models of exchange rate determination ought to include all three types of explanatory variables.