Investigating Exchange Rate Dynamics in Mozambique: A Hybrid Model Approach

Aurelio Bucuane (2020). Investigating exchange rate dynamics in Mozambique: a hybrid model approach. MSR working paper series Nr. 004-2020

31 Pages Posted: 28 Jan 2021

Date Written: November 18, 2020

Abstract


The purpose of this article is to explain the dynamics of the exchange rate in Mozambique. The applied VAR model reveals that, in fact, it is the exchange rate that determines the macroeconomic variables (fundamentals), and not the opposite (at least in the short run), as predicted in exchange rate monetary models. Variables based on market microstructure (Order Flow) have the potential to predict exchange rates, as the IRF shows a significant and consistent reaction of exchange rates to structural shocks on order flow (demand pressure), while the exchange rate reacts not only significantly less, but also in the opposite direction to that predicted in the models based on fundamentals. These results are consistent in the long run, as demonstrated by the VECM model. In addition, the exchange rate forecast, based on a hybrid model which combines macro and micro variables, exceeds the benchmark model (random walk). Furthermore, since agents’ interpretations of fundamentals are incorporated in order flows, this appears to be the transmission mechanism between macroeconomic indicators and exchange rates, and in this way, order flow helps to clarify the exchange rate puzzle identified in the literature. Finally, this article suggests the use of microstructure variables of the foreign exchange market to predict exchange rates, as well as using them as a proxy for expectations, which can contribute to effective implementation of forward-looking monetary policy.

Keywords: Hybrid Model; Monetary Policy

Suggested Citation

Bucuane, Aurélio, Investigating Exchange Rate Dynamics in Mozambique: A Hybrid Model Approach (November 18, 2020). Aurelio Bucuane (2020). Investigating exchange rate dynamics in Mozambique: a hybrid model approach. MSR working paper series Nr. 004-2020 , Available at SSRN: https://ssrn.com/abstract=3732947 or http://dx.doi.org/10.2139/ssrn.3732947

Aurélio Bucuane (Contact Author)

central bank of Mozambique ( email )

Mozambique

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