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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. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  2. Engel, Charles & West, Kenneth D., 2003. "Exchange rates and fundamentals," Working Paper Series, European Central Bank 0248, European Central Bank.
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  8. Takashi Kano, 2008. "Habit Formation and the Present-Value Model of the Current Account: Yet Another Suspect," CIRJE F-Series, CIRJE, Faculty of Economics, University of Tokyo CIRJE-F-572, CIRJE, Faculty of Economics, University of Tokyo.
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Cited by:
  1. Kano, Takashi & Morita, Hiroshi, 2014. "An Equilibrium Foundation of the Soros Chart," Discussion Papers, Graduate School of Economics, Hitotsubashi University 2014-07, Graduate School of Economics, Hitotsubashi University.

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