Excess liquidity and monetary policy implementation in a small open developing economy: The case of Mozambique

The purpose of this article is to explain the dynamics of the exchange rate in Mozambique. The applied VAR model reveals that, in fact, it is the exchange rate that determines the macroeconomic variables (fundamentals), and not the opposite (at least in the short run), as predicted in exchange rate monetary models. Variables based on market microstructure (Order Flow) have the potential to predict exchange rates, as the IRF shows a significant and consistent reaction of exchange rates to structural shocks on order flow (demand pressure), while the exchange rate reacts not only significantly less, but also in the opposite direction to that predicted in the models based on fundamentals. These results are consistent in the long run, as demonstrated by the VECM model. In addition, the exchange rate forecast, based on a hybrid model which combines macro and micro variables, exceeds the benchmark model (random walk). Furthermore, since agents’ interpretations of fundamentals are incorporated in order flows, this appears to be the transmission mechanism between macroeconomic indicators and exchange rates, and in this way, order flow helps to clarify the exchange rate puzzle identified in the literature. Finally, this article suggests the use of microstructure variables of the foreign exchange market to predict exchange rates, as well as using them as a proxy for expectations, which can contribute to effective implementation of forward-looking monetary policy.