Currency and Competitiveness in Europe
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Currency and Competitiveness in Europe

Edited by Klaus Liebscher, Josef Christl, Peter Mooslechner and Doris Ritzberger-Grünwald

This book combines currency matters with competitiveness considerations, with a view to raising the understanding of exchange rate dynamics and to analysing the role of exchange rates in reinforcing economic competitiveness.
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Chapter 8: Understanding Exchange Rates: A Micro-based Perspective on the Importance of Fundamentals

Martin D.D. Evans


Martin D.D. Evans1 INTRODUCTION 8.1 The apparent disconnect between the dynamics of spot exchange rates and macroeconomic variables over short- and medium-term horizons has been a long-standing puzzle. Surveys of the empirical literature by Frankel and Rose (1995) and Cheung, Chinn and Pascual (2005) conclude that changes in macroeconomic variables, so-called exchange rate fundamentals, can account for very little of the observed variation in spot rates over months, quarters or a year. At the same time, there is a new but rapidly growing body of evidence showing that order flows – a measure of trading patterns in the foreign exchange (FX) market – can account for a very large proportion of the variation in spot rates over days, weeks and months (for a recent survey, see Evans, 2008, Ch. 7). Many students of the FX market have interpreted these new micro-based findings as a confirmation that exchange rates are disconnected from fundamentals. Indeed, the prevalent view is that the trading patterns summarized in order flow are largely independent of macroeconomic activity, so the empirical success of microbased models leaves little role for traditional fundamentals as a source of exchange rate dynamics. This chapter puts forward a different view. I shall argue that the microbased evidence on the importance of order flows leaves plenty of room for macroeconomic fundamentals as a driver of exchange rates. In fact, microbased models represent a new perspective, based on the microeconomics of FX trading, which allows us to investigate the link between exchange rates and...

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