Evaluating Exchange Rate Models Based on Rational Expectations versus Imperfect Knowledge Economics

Abstract

Understanding the factors that explain the causes of exchange rate swings has been one of the major concerns in the international finance field. Conventional models, which utilize Rational Expectation Hypothesis (REH), are frequently tested and employed in the international finance literature to explain the exchange rate fluctuations. On the other hand, Imperfect Knowledge Economics (IKE) has recently been developed as an alternative approach to understand the same concerns on the exchange rate swings. This paper, for the first time, employs the Lakatosian framework of Scientific Research Programs (SRPs) to evaluate the main theoretical contributions of these models on the exchange rate fluctuations. First, the study evaluates the novel facts that are associated with each of the Lakatosian protective belts for both of these SRPs. In addition, the study evaluates the empirical evidence of each SRP related to these novel facts, and argues whether or not these are theoretically and empirically progressive in the Lakatosian framework.