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A New Micro Model of Exchange Rate Dynamics

  • Martin D.D. Evans
  • Richard K. Lyons

We address the exchange rate determination puzzle by examining how information is aggregated 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 the 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 macro fundamentals, (2) excess volatility relative to macro fundamentals, (3) exchange rate movements without macro news, (4) little or no exchange rate movement when macro news occurs, and (5) a structural-economic rationale for why transaction flows perform well in accounting for monthly exchange rate changes, whereas macro variables perform poorly. Though past micro analysis has made progress on results (1) through (3), results (4) and (5) are new. Excess volatility arises in our model for a new reason: rational exchange rate errors feed back into the fundamentals that the exchange rate is trying to track.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10379.

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Date of creation: Mar 2004
Date of revision:
Publication status: published as Evans, Martin D. D. and Richard K. Lyons. "Meese-Rogoff Redux: Micro-Based Exchange-Rate Forecasting," American Economic Review, 2005, v95(2,May), 405-414.
Handle: RePEc:nbr:nberwo:10379
Note: IFM
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  1. Richard K. Lyons, 1993. "Tests of Microstructural Hypotheses in the Foreign Exchange Market," NBER Working Papers 4471, National Bureau of Economic Research, Inc.
  2. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can sticky price models generate volatile and persistent real exchange rates?," Staff Report 277, Federal Reserve Bank of Minneapolis.
  3. Hoidal Bjonnes, Geir & Rime, Dagfinn, 2003. "Dealer Behavior and Trading Systems in Foreign Exchange Markets," SIFR Research Report Series 17, Institute for Financial Research.
  4. Jeanne, Olivier & Rose, Andrew K, 1999. "Noise Trading and Exchange Rate Regimes," CEPR Discussion Papers 2142, C.E.P.R. Discussion Papers.
  5. Maurice Obstfeld & Kenneth Rogoff, 1998. "Risk and Exchange Rates," NBER Working Papers 6694, National Bureau of Economic Research, Inc.
  6. Martin D. D. Evans, 2001. "FX Trading and Exchange Rate Dynamics," NBER Working Papers 8116, National Bureau of Economic Research, Inc.
  7. Devereux, Michael B. & Engel, Charles, 2002. "Exchange rate pass-through, exchange rate volatility, and exchange rate disconnect," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 913-940, July.
  8. Charles Engel, 1999. "On the Foreign Exchange Risk Premium in Sticky-Price General Equilibrium Models," International Tax and Public Finance, Springer, vol. 6(4), pages 491-505, November.
  9. Martin D.D. Evans, H. Henry Cao, Richard K. Lyons, 2003. "Inventory Information," Working Papers gueconwpa~03-03-33, Georgetown University, Department of Economics.
  10. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-60, June.
  11. Eric van Wincoop & Philippe Bacchetta, 2003. "Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?," NBER Working Papers 9498, National Bureau of Economic Research, Inc.
  12. Martin D. D. Evans and Richard K. Lyons., 1999. "Order Flow and Exchange Rate Dynamics," Research Program in Finance Working Papers RPF-288, University of California at Berkeley.
  13. Margarida Duarte & Alan C. Stockman, 2001. "Rational Speculation and Exchange Rates," NBER Working Papers 8362, National Bureau of Economic Research, Inc.
  14. Andersen, Torben G. & Bollerslev, Tim & Diebold, Francis X. & Vega, Clara, 2002. "Micro Effects of Macro Announcements: Real-Time Price Discovery in Foreign Exchange," Working Papers 02-16, Duke University, Department of Economics.
  15. Hau, Harald & Rey, Hélène, 2003. "Exchange Rates, Equity Prices and Capital Flows," CEPR Discussion Papers 3735, C.E.P.R. Discussion Papers.
  16. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
  17. Sanford J Grossman & Joseph E Stiglitz, 1997. "On the Impossibility of Informationally Efficient Markets," Levine's Working Paper Archive 1908, David K. Levine.
  18. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February.
  19. 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.
  20. Lyons, Richard K., 1997. "A simultaneous trade model of the foreign exchange hot potato," Journal of International Economics, Elsevier, vol. 42(3-4), pages 275-298, May.
  21. 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.
  22. 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.
  23. 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.
  24. Martin Evans and Richard K. Lyons, 2002. "Informational Integration and FX Trading," Working Papers gueconwpa~02-02-11, Georgetown University, Department of Economics.
  25. Campbell, John Y. & Viceira, Luis M., 2002. "Strategic Asset Allocation: Portfolio Choice for Long-Term Investors," OUP Catalogue, Oxford University Press, number 9780198296942.
  26. Richard K. Lyons, 2006. "The Microstructure Approach to Exchange Rates," MIT Press Books, The MIT Press, edition 1, volume 1, number 026262205x, June.
  27. 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.
  28. Meese, Richard, 1990. "Currency Fluctuations in the Post-Bretton Woods Era," Journal of Economic Perspectives, American Economic Association, vol. 4(1), pages 117-34, Winter.
  29. 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.
  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.
  31. Fukuda, Shin-ichi & Hoshi, Takeo & Ito, Takatoshi & Rose, Andrew, 2006. "International Finance," Journal of the Japanese and International Economies, Elsevier, vol. 20(4), pages 455-458, December.
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