This paper uses the microstructure approach for the South African foreign exchange market to determine the impact of order flow on the rand/US dollar exchange rate over the short and long term. A hybrid model which combines microeconomic and macroeconomic fundamental determinants of the exchange rate has been adopted. The analysis uses monthly series from January 2004 to December 2016 and finds that order flow explains movements in the exchange rate, both in the short and in the long term. The speed of adjustment from short-term deviations is relatively slow. The results based on the rolling-window estimation of the long-run model provide evidence of a changing relationship between order flow and the exchange rate. Consistent with the literature, the results show that the rand/dollar exchange rate reacts to fundamental variables only in the long term. Unlike Meese and Rogoff (1983), who postulate that the best way to estimate the exchange rate over the short term is with a random walk model, the current study shows that the microstructure approach can be exploited to explain short-term dynamics in the exchange rate.
Tag Archives: Working Papers
Working Paper– WP/17/01: The Quarterly Projection Model of the SARB
The macroeconomic modelling and forecasting process at the South African Reserve Bank makes use of a suite of models. This paper provides an update of the Quarterly Projection Model (QPM) – a so-called gap model – which has played an integral role in the suite since 2007. Details of the structure and functioning of the QPM model, with particular focus on the four most important gaps – the output gap, real exchange rate gap, real interest rate gap, and inflation gap (or inflation from target) – are provided. The model is then used to decompose these four gaps in order to tell a coherent story of South Africa’s macroeconomic dynamics since the inception of inflation targeting. From the perspective of the policy maker, the QPM provides a tool that quantifies the consequences of its actions on the economy, while adequately highlighting the trade-offs that are faced in the process.