Empirical evidence shows that most exchange rate volatility at short to medium
horizons is related to order flow and not to macroeconomic variables. We introduce
symmetric information dispersion about future macroeconomic fundamentals in a
dynamic rational expectations model in order to explain these stylized facts.
Consistent with the evidence, the model implies that (a) observed fundamentals
account for little of exchange rate volatility in the short to medium run, (b) over long
horizons, the exchange rate is closely related to observed fundamentals, (c) exchange
rate changes are a weak predictor of future fundamentals, and (d) the
exchange rate is closely related to order flow. (JEL F3, F4, G0, G1, E0)
Bacchetta, Philippe and Eric Van Wincoop.
2006."Can Information Heterogeneity Explain the Exchange Rate Determination Puzzle?."American Economic Review,
96(3): 552-576.DOI: 10.1257/aer.96.3.552