The Economics of Exchange Rates

The literature on exchange rate economics over the last 2 decades is reviewed, with particular reference to recent developments. It is found that the data provide support for some of the long-run relationships suggested by economic theory. This suggests that progress might be made by concentrating on the long-run determinants of exchange rates. However, it seems that further attempts to provide explanations of short-term exchange rate movements based solely on macroeconomic fundamentals may not prove successful - and this perhaps accounts for the shift toward more purely financial models of exchange rate movements and heightened interest in market microstructure. The macroeconomic fundamentals are clearly important in setting the parameters within which the exchange rate moves in the short term, but they do not appear to tell the whole story. It is in this context that the emerging literature on foreign exchange market microstructure seems especially promising.