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The Fit of Dynamic Equilibrium Models of Exchange Rate

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Abstract

The two-country monetary model has become a fundamental tool for explaining the behavior of the exchange rate. However, the popularity of this approach is not justified by its empirical support. One of the reasons for the empirical “failure” of exchange rate models could be the econometric approach applied. In this paper, an alternative procedure for evaluating the fit of dynamic equilibrium models of exchange rate is suggested. This approach is applied to three theoretical models: Lucas (1982), Svensson (1985), and Grilli and Roubini (1992).

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Paper provided by Universidad Complutense de Madrid, Facultad de Ciencias Económicas y Empresariales, Instituto Complutense de Análisis Económico in its series Documentos de Trabajo del ICAE with number 0411.

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Length: 28 pages
Date of creation: 2004
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Handle: RePEc:ucm:doicae:0411

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Keywords: Exchange rate; Equilibrium model; Seasonality.;

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References

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  1. Svensson, Lars E. O., 1985. "Currency prices, terms of trade, and interest rates: A general equilibrium asset-pricing cash-in-advance approach," Journal of International Economics, Elsevier, Elsevier, vol. 18(1-2), pages 17-41, February.
  2. Nouriel Roubini & Vittorio Grilli, 1995. "Liquidity Models in Open Economies: Theory and Empirical Evidence," NBER Working Papers 5313, National Bureau of Economic Research, Inc.
  3. Hodrick, Robert J., 1989. "Risk, uncertainty, and exchange rates," Journal of Monetary Economics, Elsevier, Elsevier, vol. 23(3), pages 433-459, May.
  4. Stockman, Alan C, 1980. "A Theory of Exchange Rate Determination," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 88(4), pages 673-98, August.
  5. Grilli, Vittorio & Roubini, Nouriel, 1992. "Liquidity and exchange rates," Journal of International Economics, Elsevier, Elsevier, vol. 32(3-4), pages 339-352, May.
  6. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  7. Bekaert, Geert, 1994. "Exchange rate volatility and deviations from unbiasedness in a cash-in-advance model," Journal of International Economics, Elsevier, Elsevier, vol. 36(1-2), pages 29-52, February.
  8. Hu, Xiaoqiang, 1997. "Macroeconomic uncertainty and the risk premium in the foreign exchange market1," Journal of International Money and Finance, Elsevier, Elsevier, vol. 16(5), pages 699-718, September.
  9. Kydland, Finn E & Prescott, Edward C, 1982. "Time to Build and Aggregate Fluctuations," Econometrica, Econometric Society, Econometric Society, vol. 50(6), pages 1345-70, November.
  10. Hansen, Lars Peter & Singleton, Kenneth J, 1982. "Generalized Instrumental Variables Estimation of Nonlinear Rational Expectations Models," Econometrica, Econometric Society, Econometric Society, vol. 50(5), pages 1269-86, September.
  11. Charles Engel, 1990. "The risk premium and the liquidity premium in foreign exchange markets," Research Working Paper, Federal Reserve Bank of Kansas City 90-07, Federal Reserve Bank of Kansas City.
  12. Meese, Richard A. & Rogoff, Kenneth, 1983. "Empirical exchange rate models of the seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, Elsevier, vol. 14(1-2), pages 3-24, February.
  13. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, Elsevier, vol. 50(2), pages 237-264, April.
  14. Helpman, Elhanan & Razin, Assaf, 1982. "A Comparison of Exchange Rate Regimes in the Presence of Imperfect Capital Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 23(2), pages 365-88, June.
  15. Dutton, John, 1993. "Real and Monetary Shocks and Risk Premia in Forward Markets for Foreign Exchange," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 25(4), pages 731-54, November.
  16. Kim, Soyoung & Roubini, Nouriel, 2000. "Exchange rate anomalies in the industrial countries: A solution with a structural VAR approach," Journal of Monetary Economics, Elsevier, Elsevier, vol. 45(3), pages 561-586, June.
  17. Bakshi, Gurdip S & Chen, Zhiwu, 1997. " Equilibrium Valuation of Foreign Exchange Claims," Journal of Finance, American Finance Association, American Finance Association, vol. 52(2), pages 799-826, June.
  18. Charles Engel, 1990. "On the foreign exchange risk premium in a general equilibrium model," Research Working Paper, Federal Reserve Bank of Kansas City 90-06, Federal Reserve Bank of Kansas City.
  19. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, Elsevier, vol. 10(3), pages 335-359.
  20. Cao, Melanie, 2001. "Systematic jump risks in a small open economy: simultaneous equilibrium valuation of options on the market portfolio and the exchange rate," Journal of International Money and Finance, Elsevier, Elsevier, vol. 20(2), pages 191-218, April.
  21. Chinn, Menzie D. & Meese, Richard A., 1995. "Banking on currency forecasts: How predictable is change in money?," Journal of International Economics, Elsevier, Elsevier, vol. 38(1-2), pages 161-178, February.
  22. Friend, Irwin & Blume, Marshall E, 1975. "The Demand for Risky Assets," American Economic Review, American Economic Association, American Economic Association, vol. 65(5), pages 900-922, December.
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