Working Paper: NBER ID: w14175
Authors: Menzie D. Chinn; Michael J. Moore
Abstract: We propose an exchange rate model which is a hybrid of the conventional specification with monetary fundamentals and the Evans-Lyons microstructure approach. It argues that the failure of the monetary model is principally due to private preference shocks which render the demand for money unstable. These shocks to liquidity preference are revealed through order flow. We estimate a model augmented with order flow variables, using a unique data set: almost 100 monthly observations on inter-dealer order flow on dollar/euro and dollar/yen. The augmented macroeconomic, or "hybrid", model exhibits out of sample forecasting improvement over the basic macroeconomic and random walk specifications.
Keywords: Exchange Rates; Order Flow; Monetary Fundamentals; Private Information
JEL Codes: D82; F31; F41; F47
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| private preference shocks (D11) | instability in money demand (E41) |
| instability in money demand (E41) | failures in conventional monetary models of exchange rates (F31) |
| monetary fundamentals (E50) | exchange rates (F31) |
| order flow (C69) | exchange rate behavior over time (F31) |
| cumulative order flow (C69) | exchange rates (F31) |