The political economy of exchange rate determination issues and empirical tests

This dissertation is in the spirit of the emerging discipline known as "behavioural finance". We have attempted to explain several observed regularities in foreign currency markets in terms of the incentives and constraints of incumbent politicians, i.e. policy-makers. The motivation for this study stems from the inability of extant exchange rate models to explain empirical realities. We have examined the behaviour of three leading currencies--the Japanese Yen, British Pound and German Mark--relative to the dollar since the dismantling of the Bretton Woods agreement.; In essence, this research addresses the question: "How does politics impact exchange rates?" By viewing the incumbent (U.S.) president as a political entrepreneur seeking to optimize an ideological objective function subject to reelection and behavioural considerations, we effectively endogenize politico-electoral dynamics into existing monetary models of the exchange rate. This approach suggests two channels through which politics impacts exchange rates: (1) indirectly, via the impact of politically-induced policy action on key "target" macroeconomic variables, and (2) directly, via the effect of political (policy) uncertainty on investor expectations.; Several results from our empirical tests are new and interesting. First, we reject the random walk hypothesis around key election dates. Second, we demonstrate that a politico-economic specification of the monetary exchange rate "news" models outperforms the standard specification. Third, we establish the existence of a political risk premium for the Japanese Yen and German Mark over our sample period. Fourth, we demonstrate that "political news" is a relevant additional regressor in any exchange rate "news" model. Fifth, we show that political uncertainty has a non-trivial impact on currency volatility. Close to an election, negative innovations impact the volatility of the Yen and Mark significantly more than do positive innovations.; Our results suggest several useful extensions of this research. In sum however, we have demonstrated that given computationally-imperfect, but procedurally rational investors, some of the cornerstones of modern finance, namely the random walk, substantive rationality and the maximizing paradigm are not as robust to behavioural considerations as was once believed. Importantly, we have offered some insight into the impact of a relatively "non-quantifiable", though crucially relevant factor such as politics, on asset markets.