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A New Micro Model of Exchange Rate Dynamics (March 2004)

We address the puzzle of what determines exchange rates by examining information aggregation in a dynamic general equilibrium (DGE) setting. Unlike other DGE macro models, which enrich either preference structures or production structures, our model enriches the information structure. The model departs from microstructure-style modeling by identifying real activities where dispersed information originates, as well as the technology by which information is subsequently aggregated and impounded. Results relevant to the determination puzzle include: (1) persistent gaps between exchange rates and fundamentals, (2) excess volatility relative to fundamentals, (3) exchange rate movements without macro news, (4) little or no exchange rate movement when macro news occurs, and (5) a structural rationale for why transaction flows perform well in accounting for monthly exchange rate changes, whereas macro variables perform poorly.

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Paper provided by Georgetown University, Department of Economics in its series Working Papers with number gueconwpa~05-05-04.

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Date of creation: 04 May 2005
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Handle: RePEc:geo:guwopa:gueconwpa~05-05-04
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Georgetown University Department of Economics Washington, DC 20057-1036

Phone: 202-687-6074
Fax: 202-687-6102
Web page: http://econ.georgetown.edu/
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Order Information: Postal: Roger Lagunoff Professor of Economics Georgetown University Department of Economics Washington, DC 20057-1036
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  1. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
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  3. Michael B. Devereux & Charles Engel & Peter E. Storgaard, 2003. "Endogenous Exchange Rate Pass-through when Nominal Prices are Set in Advance," IEHAS Discussion Papers 0304, Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences.
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  13. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
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  15. Martin D.D. Evans, H. Henry Cao, Richard K. Lyons, 2003. "Inventory Information," Working Papers gueconwpa~03-03-33, Georgetown University, Department of Economics.
  16. Evans, Martin D.D. & Lyons, Richard K., 2008. "How is macro news transmitted to exchange rates?," Journal of Financial Economics, Elsevier, vol. 88(1), pages 26-50, April.
  17. Kenneth A. Froot & Tarun Ramadorai, 2002. "Currency Returns, Institutional Investor Flows, and Exchange Rate Fundamentals," NBER Working Papers 9101, National Bureau of Economic Research, Inc.
  18. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, vol. 85(1), pages 201-18, March.
  19. Lyons, Richard K., 1995. "Tests of microstructural hypotheses in the foreign exchange market," Journal of Financial Economics, Elsevier, vol. 39(2-3), pages 321-351.
  20. Giancarlo Corsetti & Paolo Pesenti & Nouriel Roubini, 2002. "The Role of Large Players in Currency Crises," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 197-268 National Bureau of Economic Research, Inc.
  21. Jeffrey A. Frankel & Giampaolo Galli & Alberto Giovannini, 1996. "Introduction to "The Microstructure of Foreign Exchange Markets"," NBER Chapters, in: The Microstructure of Foreign Exchange Markets, pages 1-18 National Bureau of Economic Research, Inc.
  22. Jon Faust & John H. Rogers & Eric T. Swanson & Jonathan H. Wright, 2002. "Identifying the effects of monetary policy shocks on exchange rates using high frequency data," International Finance Discussion Papers 739, Board of Governors of the Federal Reserve System (U.S.).
  23. David Backus & Patrick J. Kehoe & Finn E. Kydland, 1992. "Dynamics of the Trade Balance and the Terms of Trade: The S-Curve," NBER Working Papers 4242, National Bureau of Economic Research, Inc.
  24. Jeanne, Olivier & Rose, Andrew K, 1999. "Noise Trading and Exchange Rate Regimes," CEPR Discussion Papers 2142, C.E.P.R. Discussion Papers.
  25. Paul Milgrom & Nancy L.Stokey, 1979. "Information, Trade, and Common Knowledge," Discussion Papers 377R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  26. Martin Evans and Richard K. Lyons, 2002. "Informational Integration and FX Trading," Working Papers gueconwpa~02-02-11, Georgetown University, Department of Economics.
  27. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942, June.
  28. Harald Hau & William Killeen & Michael Moore, 2002. "How has the euro changed the foreign exchange market?," Economic Policy, CEPR;CES;MSH, vol. 17(34), pages 149-192, 04.
  29. Martin D. D. Evans & Richard K. Lyons, 2007. "Exchange Rate Fundamentals and Order Flow," NBER Working Papers 13151, National Bureau of Economic Research, Inc.
  30. Derviz, Alexis, 2004. "Asset return dynamics and the FX risk premium in a decentralized dealer market," European Economic Review, Elsevier, vol. 48(4), pages 747-784, August.
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  33. Covrig, Vicentiu & Melvin, Michael, 2002. "Asymmetric information and price discovery in the FX market: does Tokyo know more about the yen?," Journal of Empirical Finance, Elsevier, vol. 9(3), pages 271-285, August.
  34. Martin D.D. Evans & Richard K. Lyons, 2004. "A New Micro Model of Exchange Rate Dynamics," NBER Working Papers 10379, National Bureau of Economic Research, Inc.
  35. Payne, Richard, 2003. "Informed trade in spot foreign exchange markets: an empirical investigation," Journal of International Economics, Elsevier, vol. 61(2), pages 307-329, December.
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