Heterogeneity of agents, transactions costs and the exchange rate

We develop a model of the exchange rate that has two features. First, there are nonlinearities that arise from the existence of transaction costs in goods markets. Second, the model assumes heterogeneous agents who use simple forecasting rules, the 'fitness' of which is then controlled ex post by checking their profitability, and by switching to the more profitable rules. This model is capable of reproducing the empirical puzzles observed in exchange markets (disconnect puzzle, excess volatility, fat tails, volatility clustering). We analyse some policy implications of this type of modelling of the exchange rate. (c) 2004 Elsevier B.V. All rights reserved.