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Inattentive Search for Currency Fundamentals

Inattentive Search for Currency Fundamentals We test the rational inattention theory of exchange rates and proxy attention for different economic fundamentals by the search volume of related search queries on Google. We demonstrate that the higher the attention to a certain fundamental, the better its ability to forecast exchange rate movements. Our forecasts based on fundamental model selection by Google Trends significantly outperform the random walk, both statistically and economically. The best forecasts and the highest investment returns are systematically delivered by models that select the most salient fundamental. Both the survey expectations and the predicted currency returns are more persistent than their actual counterparts, consistent with the underreaction to economic news hypothesis. Investment returns are substantially higher during periods of elevated uncertainty, as a result of increased attention. Our findings provide strong support in favor of the rational inattention theory of exchange rates and the similar behaviour of the attention-based forecasts, and survey expectations suggest that the rational inattention operates via the expectation-formation channel. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png IMF Economic Review Springer Journals

Inattentive Search for Currency Fundamentals

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References (44)

Publisher
Springer Journals
Copyright
Copyright © International Monetary Fund 2023. Springer Nature or its licensor (e.g. a society or other partner) holds exclusive rights to this article under a publishing agreement with the author(s) or other rightsholder(s); author self-archiving of the accepted manuscript version of this article is solely governed by the terms of such publishing agreement and applicable law.
ISSN
2041-4161
eISSN
2041-417X
DOI
10.1057/s41308-022-00195-3
Publisher site
See Article on Publisher Site

Abstract

We test the rational inattention theory of exchange rates and proxy attention for different economic fundamentals by the search volume of related search queries on Google. We demonstrate that the higher the attention to a certain fundamental, the better its ability to forecast exchange rate movements. Our forecasts based on fundamental model selection by Google Trends significantly outperform the random walk, both statistically and economically. The best forecasts and the highest investment returns are systematically delivered by models that select the most salient fundamental. Both the survey expectations and the predicted currency returns are more persistent than their actual counterparts, consistent with the underreaction to economic news hypothesis. Investment returns are substantially higher during periods of elevated uncertainty, as a result of increased attention. Our findings provide strong support in favor of the rational inattention theory of exchange rates and the similar behaviour of the attention-based forecasts, and survey expectations suggest that the rational inattention operates via the expectation-formation channel.

Journal

IMF Economic Review – Springer Journals

Published: Dec 1, 2023

Keywords: F31; F41; E44

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