Nominal exchange rates in low-inflation advanced countries are nearly random walks. Engel and West (2003a) offer an explanation for this in the context of models in which the exchange rate is determined as the discounted sum of current and expected future fundamentals. Engel and West show that if the fundamentals are I(1), then as the discount factor approaches one, the exchange rate becomes indistinguishable from a random walk. An alternative explanation for the random-walk behavior of exchange rates is that there are some unobserved variables that drive exchange rates that follow near random walks. This paper takes the approach that both explanations are possible. We are able to measure how much of exchange-rate variation could be accounted for by the Engel-West explanation, despite the fact that we do not observe the information set of financial markets. We find that the observable fundamentals (money, income, prices, interest rates) may account for about 40 percent of the variance of changes in exchange rates under the assumption of discount factors near unity.
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number
10267.
Length: Date of creation: Feb 2004 Date of revision: Handle: RePEc:nbr:nberwo:10267
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Find related papers by JEL classification: F31 - International Economics - - International Finance - - - Foreign Exchange G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
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Charles Engel & Kenneth D. West, 2003.
"Exchange rates and fundamentals,"
Proceedings,
Federal Reserve Bank of San Francisco, issue Mar.
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