Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?

Abstract

Empirical evidence shows that most exchange rate volatility at short to medium horizons is related to order flow and not to macroeconomic variables. We introduce symmetric information dispersion about future macroeconomic fundamentals in a dynamic rational expectations model in order to explain these stylized facts. Consistent with the evidence, the model implies that (a) observed fundamentals account for little of exchange rate volatility in the short to medium run, (b) over long horizons, the exchange rate is closely related to observed fundamentals, (c) exchange rate changes are a weak predictor of future fundamentals, and (d) the exchange rate is closely related to order flow. (JEL F3, F4, G0, G1, E0)

Heterogeneity in Economics

“…What is important to note here is, that if there is a return to fundamental it should not be, and is not, in our model, permanent. If agents learn about the true fundamentals and the prices then adhere to those fundamentals as in Bacchetta and van Wincoop (2005), bubble-like departures would cease to occur. In our model such bubbles will continue to develop and to burst.…”

“…Without them, one could not explain as Bacchetta and van Wincoop (2005) point out, the enormous volume of trade on financial markets. Spot trading on foreign exchange markets in 2001 was approximately $1.2 trillion per day, for example.…”

Optimal Monetary Policy in Open Economies

“…The size or even the sign of the gaps in relative demand and international prices shaping policy trade-offs in open economies can vary significantly with the values of preference parameters such as s and f, the degree of openness, the nature and persistence of shocks, and especially the structure of financial markets. 44 A long-standing view is that the exchange rate may be driven by nonfundamentals, see Jeanne and Rose (2002) and Bacchetta and Van Wincoop (2006). 45 For an early contribution on the topic, see Dellas (1988).…”

Asymmetry in the effects of economic fundamentals on rising and falling exchange rates

“…Empirical evidence on the relationship between exchange rates and fundamentals suggests that fundamentals play little role in explaining exchange rate movements in the short to medium run, but over longer horizons, exchange rates are driven primarily by fundamentals (Bacchetta & Van Wincoop, 2003). One of the popular explanations proposed in the literature was that unexplained large shocks to floating rates then must be due to innovations in unobservable fundamentals or to non-fundamental factors such as speculative bubbles (for example, research by Frankel and Rose, 1998).…”