Deterministic Chaos in the Foreign Exchange Markets

Linear models in which exchange rates are driven by stochastic `news' are subject to a number of failings. In this paper we present a non-linear, deterministic model, incorporating concepts from chaos theory, which is capable of producing unpredictable exchange rate movements without `news'. Two non-linearities arise from a J-curve effect in the trade balance and the modelling of both `chartist' and `fundamental' influences in expectations formation. The model displays extreme sensitivity to only small changes in its initial conditions and its parameter values - one of the requirements for a model to generate chaotic behaviour. Only a few periods after such changes, the time path of the exchange rate appears to have been generated from a totally different model. This implies that forecasts based on exchange rate models are effectively impossible, because the tiniest errors generate totally different paths for the exchange rate. The results warn against excessive reliance on `news' to explain exchange rate movements.