Macro Lessons from Microstructure

Abstract

Empirical research on the microeconomics of currency markets, an area known sometimes as currency market microstructure, has taken off in the past decade. This paper extracts from this research four lessons for modeling short-run exchange-rate dynamics. The first lesson is this: Currency flows are key, so models should focus on flows and equilibrium may be defined by equality between purchases and sales. The remaining three lessons concern the economic forces behind currency flows. Second lesson: Models should distinguish financial traders, who essentially use currencies as a store of value, from commercial traders, who use currencies as a medium of exchange. At short horizons cumulative financial flows have a positive relationship with exchange rates while cumulative commercial flows have a negative relationship. Third lesson: Financial traders are motivated by profits, rather than consumption, and their risk-taking will be constrained. Fourth lesson: Commercial traders are motivated by exchange-rate levels and rationally choose not to speculate. The paper notes that the workhorse models of international macroeconomics do not fit most of these lessons. These important lacunae in their microfoundations may help explain their limited empirical success. The paper sketches an optimizing model of currency flows that is consistent with the lessons. This model fits many of the puzzles associated with floating rates and predicts better than the random walk.

Keywords: microstructure, international macroeconomics, exchange rate, exchange-rate model, order flow, liquidity, currency trading

JEL Classification: F31