Heterogeneity of agents, transactions costs and the exchange rate

We develop a model of the exchangerate that has two features. First, there are non-linearities that arise from the existence of transactioncosts 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 exchangerate.