Non-rational beliefs in an open economy

This paper proposes a new theory of exchange rate determination. Under arbitrary beliefs, the exchange rate is determined by an equilibrium restriction which we call the generalized no-arbitrage condition. The pricing function predicts endogenous departures from the conventional rational expectations uncovered interest parity condition. In an empirical open-economy model with learning, using Canadian and United States data, we evaluate whether learning can account for exchange rate dynamics and reduce reliance on exogenous risk-premium shocks to explain departures from uncovered interest parity. Reminiscent of Justiniano and Preston (2010a), we find learning dynamics help explain the persistence and volatility of exchanges rates but generate counter-factual predictions on international macroeconomic comovement.