Markiewicz, AgnieszkaP., Verhoeks, RalphC., Verschoor, WillemF.C. and Zwinkels, RemcoC.J. (2023). Inattentive Search for Currency Fundamentals IMF Economic Review, 71(4):907--952.
JournalIMF Economic Review
We test the rational inattention theory of exchange rates and proxy attention for different economic fundamentals by the search volume of related search queries on Google. We demonstrate that the higher the attention to a certain fundamental, the better its ability to forecast exchange rate movements. Our forecasts based on fundamental model selection by Google Trends significantly outperform the random walk, both statistically and economically. The best forecasts and the highest investment returns are systematically delivered by models that select the most salient fundamental. Both the survey expectations and the predicted currency returns are more persistent than their actual counterparts, consistent with the underreaction to economic news hypothesis. Investment returns are substantially higher during periods of elevated uncertainty, as a result of increased attention. Our findings provide strong support in favor of the rational inattention theory of exchange rates and the similar behaviour of the attention-based forecasts, and survey expectations suggest that the rational inattention operates via the expectation-formation channel.