Exchange rate volatility: Intraregime Volatility: Foreign Exchange Microstructure
All of the foregoing research assumes that expectations are homogeneous. Bacchetta and Wincoop (2003) build on the idea that the heterogeneity of investors may also be important for an understanding of exchange rate dynamics, however. In particular, they introduce two types of investor heterogeneity that have been associated with order flow into a standard variant of the monetary model. The first type is the heterogeneous information of market participants about future macro fundamentals a dispersion effect and the second is heterogeneity due to nonfundamentals. The latter includes noise traders and rational traders who trade for nonspeculative reasons, such as liquidity trades, or trades associated with differential access to private investment opportunities. Bacchetta and Wincoop demonstrate how information heterogeneity produces both a magnification effect on the exchange rate and endogenous persistence of the impact of nonfundamentals on the exchange rate. Using a simulation exercise and plausible parameter values, the authors demonstrate that there is a substantial magnification effect as a result of information dispersion, and a substantial part of this seems to be attributable to the role of higher-order expectations due to the infinite regress.
A number of economists have attempted to gauge the forward-looking monetary model as written in (1) and its speculative bubble variant given in (2) (e.g., see MacDonald and Taylor 1993). The evidence, in general, does not support themagnification story, although this could simply reflect the model specifications used. The research gives some support to the speculative bubbles hypothesis, although such tests could simply be picking up some other extraneous influence on the exchange rate (see, e.g., Engel andWest 2004). More favorable empirical evidence has been reported for the overshootingmodel, while tests of the more recent NOEM variants of the monetary model have not yet begun. So, at best, we can conclude from this empirical evidence that the jury is still out on the validity of the various theoretical explanations for intraregime volatility (see also Arnold, MacDonald, and de Vries 2005).