Postprint version. Published in Journal of International Money and Finance, Volume 25, Issue 1, February 1, 2006, pages 48-70. Copyright © 2005 Elsevier. The definitive version is available at http://dx.doi.org/10.1016/j.jimonfin.2005.10.004.
NOTE: At the time of publication, the author Eric Fisher was not yet affiliated with Cal Poly.
This paper explores a model of bond prices where agents have diverse prior beliefs about domestic and foreign inflation. In the long run, the foreign exchange forward premium reflects expected differences in inflation, but in the short run, it depends upon the diversity of prior beliefs. If some people have diffuse priors about a country's inflation process, then its currency commands a forward premium that is eventually dissipated. Using data on the dollar–mark premium from the 1980s, it shows that this kind of diversity really matters. Thus models with a single representative agent give an inadequate description of the data.