Monetary Policy Uncertainty and the Forward Bias for Foreign Exchange

This paper provides a theoretical discussion of the forward premium anomaly. We reformulate the well-known Lucas (1982) model by allowing for the existence of monetary policy regimes. The monetary supply is viewed as having two stochastic components: a) a persistent component that reflects the preferences of the central bank regarding the long-run money supply or inflation target, and b) a transitory component that represents short-lived interventions. To generate agents' forecasts, we consider two scenarios: a) consumers can distinguish the permanent and the transitory components of the money supply, and b) consumers can observe only historical series of the aggregate monetary supply and face a signal-extraction problem. We simulate the model from a carefully conducted calibration using quarterly data from the US and Canada for the period 1984:2 to 2004:1. Numerical simulations reveal that, under complete information, forward unbiasedness cannot be rejected at coventionally significant levels. However, when agents need to learn by doing, forward bias systematically appears. The claim made in this paper is that when learning about monetary policy is incorporated, the forward bias can be reproduced without artificially assuming either an extremely high persistence in consumption or an unreasonable degree of risk aversion.