Order Flow and the Monetary Model of Exchange Rates: Evidence from a Novel Data Set

Authors


  • We are grateful to Maurice Roche; Ken West; our discussant Martin Evans; participants at the IMF Conference on International Macro Finance (April 2008), the NBER International Finance and Macro meetings (March 2009), seminars at University of North Carolina, University of Pittsburgh, Trinity College Dublin, Lancaster University, and the University of Bristol; two anonymous referees; and the editor for their very helpful comments.

Abstract

We propose an exchange rate model that is a hybrid of the conventional specification with monetary fundamentals and the Evans–Lyons microstructure approach. We estimate a model augmented with order flow variables, using a unique data set: almost 100 monthly observations on interdealer order flow on dollar/euro and dollar/yen. The augmented macroeconomic, or “hybrid,” model exhibits greater in-sample stability and out of sample forecasting improvement vis-à-vis the basic macroeconomic and random walk specifications.

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