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The Microstructure Approach: New Details on Exchange Rates in the Short-Run

When it comes to exchange rate determination, keep an eye on research about Microstructure of Foreign Exchange Markets. This is a relatively new approach to exchange rate determination in the short-run.

While macroeconomic fundamentals such as inflation rates, nominal interest rates, and so on are helpful in predicting long-run changes in exchange rates, their predictive power significantly drops when it comes to explaining short-run changes in exchange rates. Recently, the microstructure approach has been introduced as a new framework that would help our understanding of short-term exchange rate dynamics.

Some economists argue that macroeconomic fundamentals-based exchange rate determination models are missing certain market-related dynamics. In particular, these models do not accurately depict the currency trading process, which matters in the short-run. Therefore, because macro-based exchange rate determination models don’t reflect the important pieces of the reality about currency trading, they can’t provide accurate predictions regarding the short-run changes in exchange rates.

In contrast, the microstructure approach examines the characteristics of the currency trading process. This approach points out to the imbalance in the sequence of purchases and sales of currencies in foreign exchange markets.

Order flow is an important concept in microstructure models of exchange rate determination, which means the net of the buyer-initiated and seller-initiated orders in foreign exchange markets. It's believed that order flow conveys information on exchange rate fundamentals. However, heterogeneous beliefs over exchange rate fundamentals lead to imbalances in order flow.

The microstructure approach also recognizes different market participants and their interactions in these markets. Among these participants are financial agents (dealers and brokers representing banks and other financial institutions) and commercial agents (people representing multinational companies). According to the microstructure approach, there may be imbalances between buyer-initiated and seller-initiated trades in foreign exchange markets.

Try conducting a web search under “FX microstructure.” You’ll have access to a number of publications on this exciting subject.

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