What Drives Movements in Exchange Rates?

Bank of Canada Review, 2005

14 Pages Posted: 20 Apr 2006

See all articles by Michael R. King

Michael R. King

Gustavson School Of Business

Jeannine Bailliu

Bank of Canada

Abstract

Drawing on both macroeconomic and micro-based exchange rate models, the authors revisit the academic literature on exchange rate determination and summarize the state of knowledge about what drives movements in exchange rates. The focus is on highlighting recent advances in our understanding while identifying promising alternative approaches for future research. Models of exchange rate determination based on macroeconomic fundamentals have not had much success in either explaining or forecasting exchange rates, possibly owing to the simplifying assumptions employed. Notwithstanding this, researchers at the Bank of Canada have developed an exchange rate equation that has been relatively successful at tracking most of the major movements in the Canadian dollar over the past few decades and has proven to be stable over time. Micro-based models of exchange rates examine more complex and realistic settings where information is dispersed, investors are heterogeneous, and market trading rules and institutions affect behaviour. This line of research provides better explanations of short-term dynamics in exchange rates and has been found to provide superior forecasts of exchange rate movements over time horizons ranging from one day to one month. One promising area of research involves uniting the macro- and micro-based exchange rate models in order to explain movements over short-, medium-, and long-term horizons.

Keywords: foreign exchange, macro models, microstructure, Canadian dollar

JEL Classification: F31, F41, G15

Suggested Citation

King, Michael Robert and Bailliu, Jeannine, What Drives Movements in Exchange Rates?. Bank of Canada Review, 2005, Available at SSRN: https://ssrn.com/abstract=896324

Michael Robert King (Contact Author)

Gustavson School Of Business ( email )

University of Victoria
Business & Economics Building, Room 246
Victoria, British Columbia V8W 2Y2
Canada
250-721-6425 (Phone)

HOME PAGE: http://https://www.uvic.ca/gustavson/faculty/faculty/faculty/current/kingm.php

Jeannine Bailliu

Bank of Canada ( email )

Ottawa, Ontario K1A 0G9
Canada
613-782-7474 (Phone)
613-782-7658 (Fax)

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