Private Information and a Macro Model of Exchange Rates: Evidence from a Novel Data Set
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.
We are grateful for the comments of our discussant Martin Evans and other participants at the Conference on International Macro Finance - April 24-25, 2008 at the International Monetary Fund, Washington D.C. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research.