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Exchange rates and fundamentals: a generalization

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  • James M. Nason
  • John H. Rogers

Abstract

Exchange rates have raised the ire of economists for more than twenty years. The problem is that few, if any, exchange rate models are known to systematically beat a naive random walk in out-of-sample forecasts. Engel and West (2005) show that these failures can be explained by the standard present value model (PVM) because it predicts random walk exchange rate dynamics if the discount factor approaches one and fundamentals have a unit root. This paper generalizes the Engel and West hypothesis to the larger class of open economy dynamic stochastic general equilibrium (DSGE) models. The Engel and West hypothesis is shown to hold for a canonical open economy DSGE model. We show that all the predictions of the standard PVM carry over to the DSGE PVM. The DSGE PVM also yields unobserved components (UC) models that we estimate using Bayesian methods and a quarterly Canadian-U.S. sample. Bayesian model evaluation reveals that the data support a UC model that calibrates the discount factor to one, implying the Canadian dollar–U.S. dollar exchange rate is a random walk dominated by permanent cross-country monetary and productivity shocks.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Atlanta in its series Working Paper with number 2008-16.

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Date of creation: 2008
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Handle: RePEc:fip:fedawp:2008-16

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Keywords: Foreign exchange rates;

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Citations

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Cited by:
  1. Jian Wang & Jason J. Wu, 2008. "The Taylor rule and forecast intervals for exchange rates," Globalization and Monetary Policy Institute Working Paper 22, Federal Reserve Bank of Dallas.
  2. Rabanal, Pau & Rubio-Ramírez, Juan F. & Tuesta, Vicente, 2011. "Cointegrated TFP processes and international business cycles," Journal of Monetary Economics, Elsevier, vol. 58(2), pages 156-171, March.
  3. Philippe Bacchetta & Eric van Wincoop, 2009. "On the Unstable Relationship between Exchange Rates and Macroeconomic Fundamentals," NBER Working Papers 15008, National Bureau of Economic Research, Inc.
  4. Pau Rabanal & Juan F. Rubio-Ramirez, 2012. "Can International Macroeconomic Models Explain Low-Frequency Movements of Real Exchange Rates?," IMF Working Papers 12/13, International Monetary Fund.
  5. 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.
  6. Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.

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