Fixed versus Flexible: Lessons from EMS Order Flow / William P. Killeen, Richard K. Lyons, Michael J. Moore.

Format:

Book

Author/Creator:

Killeen, William P.

Contributor:

National Bureau of Economic Research.

Lyons, Richard K.

Moore, Michael J.

Series:

Working Paper Series (National Bureau of Economic Research) no. w8491.

NBER working paper series no. w8491

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Other Title:

Fixed versus Flexible

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2001.

Summary:

This paper addresses the puzzle of regime-dependent volatility in foreign exchange. We extend the literature in two ways. First, our microstructural model provides a qualitatively new explanation for the puzzle. Second, we test implications of our model using Europe's recent shift to rigidly fixed rates (EMS to EMU). In the model, shocks to order flow induce volatility under flexible rates because they have portfolio-balance effects on price, whereas under fixed rates the same shocks do not have portfolio-balance effects. These effects arise in one regime and not the other because the elasticity of speculative demand for foreign exchange is (endogenously) regime-dependent: low elasticity under flexible rates magnifies portfolio-balance effects; under credibly fixed rates, elasticity of speculative demand is infinite, eliminating portfolio-balance effects. New data on FF/DM transactions show that order flow had persistent effects on the exchange rate before EMU parities were announced. After announcement, determination of the FF/DM rate was decoupled from order flow, as predicted by the model.

Notes:

Print version record

September 2001.