What Drives Movements in Exchange Rates?

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