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88 CHAPTER 3. THE MONETARY MODEL25201510exchange ratewith bubble50-5fundamentals-101 26 51 76 101 126 151 176Figure 3.3: A realization of a rational bubble where ψ =0.99, and thefundamentals follow a random walk. The stable line is the realization of thefundamentals.Now it may be the case that the foreign exchange market is occasionallydriven by bubbles but real-world experience suggests that suchbubbles eventually pop. It is unlikely that foreign exchange marketsare characterized by rational bubbles which do not pop. As a result,we will focus on the no-bubbles solution from this point on.3.4 Fundamentals and Exchange Rate VolatilityA major challenge to international economic theory is to understandthe volatility of the exchange rate in relation to the volatility of theeconomic fundamentals. Let’s Þrst take a look at the stylized factsconcerning volatility. Then we’ll examine how the monetary model isable to explain these facts.