This is an attempt to explain forward discount bias in the foreign exchange
market as influenced by monetary policy rules. A government response function
to external shocks is combined with the monetary model for exchange rate
determination, and the risk premium is assumed to follow a first order
autoregressive process. The forward discount bias is more probable when the
government is concerned with interest rate or money supply stability than when
monetary policy focuses on the stabilization of foreign exchange rate or price
level. These results are consistent with the experiences of ERM in the past –
where forward discount bias is not found – and the survey results of Froot and
Thaler (1990).