30. The microstructure/micro-finance approach to exchange rates

The vast empirical failure of standard macro exchange rate determination models in explaining exchange rate movements motivates the development of microstructure approach to exchange rates in the 1990s. The microstructure approach of incorporating “order flow” in empirical models has gained considerable popularity in recent years, since its superior performance to macro exchange rate models in explaining exchange rate behavior. It is shown that order flow can explain about 60 percent of exchange rate movements versus 10percent at most in standard exchange rate empirical models. As the microstructure approach to exchange rates is an active ongoing research area, this chapter briefly discusses key concepts that constitute the approach.