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Exchange Rates and Fundamentals

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  • Charles Engel
  • Kenneth D. West

Abstract

We show analytically that in a rational expectations present value model, an asset price manifests near random walk behavior if fundamentals are I(1) and the factor for discounting future fundamentals is near one. We argue that this result helps explain the well known puzzle that fundamental variables such as relative money supplies, outputs, inflation and interest rates provide little help in predicting changes in floating exchange rates. As well, we show that the data do exhibit a related link suggested by standard models - that the exchange rate helps predict these fundamentals. The implication is that exchange rates and fundamentals are linked in a way that is broadly consistent with asset pricing models of the exchange rate.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10723.

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Date of creation: Aug 2004
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Handle: RePEc:nbr:nberwo:10723

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  1. Charles Engel, 1996. "The Forward Discount Anomaly and the Risk Premium: A Survey of Recent Evidence," NBER Working Papers 5312, National Bureau of Economic Research, Inc.
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