The literature has also established linkages between movements in exchange rates and order flows in foreign exchange markets. In the very short run, order flow – the volume of buy and sell requests and the related willingness of dealers to trade at certain prices – affects exchange rate behaviour over periods varying from minutes to a couple of months (see Lyons (1995, 2001) and Sarno and Taylor (2002) for reviews). This link seems to reflect in part the micro market structure of trading as well as the information gleaned by traders from the positions of other market participants. It also appears to be related to the information contained by order flows about the underlying macroeconomic factors and parameters of exchange rate processes.

In particular, traders respond to economic news in deciding what currencies to buy and sell, and that order flow is a powerful predictor of future exchange rates (Breedon et al (2016) and Menkhoff et al (2016)). Rime et al (2010) argue that taken together the two results imply that economic variables are indeed linked to exchange rates but that the link is likely to be partly indirect in the sense that it is established via the trading decisions of dealers rather than via the macroeconomic channel posited by standard rational expectations models. On a related note, Evans (2010) presents evidence that order flow information reaching dealers provides signals concerning the slowly evolving state of the macroeconomy (see also Evans (2011) for a review of this and the associated literature).

Another possible channel is that the order flow provides information about the (true or perceived) parameters of the exchange rate process – information, which, in turn, affects exchange rate behaviour. Consistent with this hypothesis, Chinn and Moore (2011) show that combining a standard monetary model with order flow information can improve out-of-sample exchange rate forecasting. Furthermore, Fratzscher et al (2015) find that a large fraction of the variation and directional change in exchange rates can be explained by a combination of order flow and survey data on the relative importance attributed by traders to various fundamental factors. This supports the “scapegoat” theory of exchange rates (Bacchetta and van Wincoop (2004), Bacchetta et al (2010) and Tille and van Wincoop (2014a)).

Exchange rate behaviour could also be linked to the level of financial development and to global saving-investment dynamics. Caballero et al (2008) argue that the lack of welldeveloped financial systems leads developing economies to run persistent current account surpluses with countries that can generate “sound” or liquid financial assets (such as the United States). In addition, they show that shifts in growth rates, in the presence of home bias in consumption and portfolio holdings, can lead to changes in exchange rates. In their model, the exchange rate moves in response to financial shocks rather than to the current account balance. Using this model, they explain how the GFC exacerbated the shortage of liquid assets and induced a rush to dollar assets (see also Della Corte et al (2016b)).

There is also evidence suggesting that the safe haven function of some currencies allows them to enjoy a privileged cost of capital and liquidity. The United States, for example, appears to pay less on its external liabilities than it earns on comparable external assets, correcting for exchange rate movements (Gourinchas et al (2010)). The relatively sharp appreciation of the US dollar following the GFC appears to be related to this role.<sup>58</sup> Curcuru et al (2013), however, find that the hypothesis of an exorbitant privilege – insofar as portfolio claims are concerned – suffers from a number of weaknesses, including measurement problems and statistical insignificance, and can largely be explained by differences in the relative

> 58 Gourinchas and Rey (2014) review the literature on the so-called “exorbitant privilege” enjoyed by the United States (see also Gorton (2017) for a review of the general literature on safe assets and Cohen et al (2017) for a review of the literature on global liquidity). McCauley and McGuire (2009) for their part focus on bank behaviour in the context of the US dollar’s appreciation after the GFC.

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