Handbook of Exchange Rates

13.1 Introduction

Most models of exchange rate determination make a set of heroic assumptions about the information with which investors operate in the foreign exchange (FX) market. In particular, investors are assumed to (i) have identical information; (ii) perfectly know the model; and (iii) use all available information at all times. These assumptions are typical in macroeconomics and are technically convenient. However, recent research has shown that these abstractions about the information structure have crucial implications and that relaxing them can shed light on a wide range of important exchange rate puzzles. In this chapter, we review a number of models that we have developed in previous work to relax these restrictive assumptions on information. We also review some related literature.

It is not difficult to argue that the “benchmark” information structure commonly used in models of exchange rate determination bears little resemblance to reality. The assumption of common information held by all investors is inconsistent with various observations. First, there is an enormous volume of trade in the FX market (larger than in any other financial market), reflecting differences among investors. Second, investors have different expectations about future macro variables such as GDP and prices as well as future exchange rates themselves. Third, the close link between exchange rates and order flow, first documented by Evans and Lyons (2002), suggests that the exchange rate primarily ...