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Exchange Rates and Fundamentals: Closing a Two-country Model

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  • Takashi Kano

Abstract

In an influential paper, Engel and West (2005) claim that the near random-walk behavior of nominal exchange rates is an equilibrium outcome of a variant of present-value models when economic fundamentals follow exogenous first-order integrated processes and the discount factor approaches one. Subsequent empirical studies further confirm this proposition by estimating a discount factor that is close to one under distinct identification schemes. In this paper, I argue that the unit market discount factor implies the counterfactual joint equilibrium dynamics of random-walk exchange rates and economic fundamentals within a canonical, two-country, incomplete market model. Bayesian posterior simulation exercises of a two-country model based on post-Bretton Woods data from Canada and the United States reveal difficulties in reconciling the equilibrium random-walk proposition within the two-country model; in particular, the market discount factor is identified as being much lower than one.

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Bibliographic Info

Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2013-62.

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Length: 40 pages
Date of creation: Sep 2013
Date of revision:
Handle: RePEc:een:camaaa:2013-62

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Keywords: Exchange rates; Present-value model; Economic fundamentals; Random walk; Two-country model; Incomplete markets; Cointegrated TFPs; Debt elastic risk premium;

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  1. James M. Nason & John H. Rogers, 2003. "The present-value model of the current account has been rejected: round up the usual suspects," International Finance Discussion Papers 760, Board of Governors of the Federal Reserve System (U.S.).
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  14. Michel Normandin & Martin Boileau, 2005. "Closing International Real Business Cycle Models with Restricted Financial Markets," Cahiers de recherche 05-03, HEC Montréal, Institut d'économie appliquée.
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  16. Pau Rabanal & Juan Francisco Rubio-Ramirez & Vicente Tuesta Reátegui, 2010. "Cointegrated TFP Processes and International Business Cycles," Working Papers 10-11, Duke University, Department of Economics.
  17. Balke, Nathan S. & Ma, Jun & Wohar, Mark E., 2013. "The contribution of economic fundamentals to movements in exchange rates," Journal of International Economics, Elsevier, vol. 90(1), pages 1-16.
  18. Bodenstein, Martin, 2011. "Closing large open economy models," Journal of International Economics, Elsevier, vol. 84(2), pages 160-177, July.
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