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Exchange rates and fundamentals

  • Engel, Charles
  • West, Kenneth D.

Standard economic models hold that exchange rates are influenced by fundamental variables such as relative money supplies, outputs, inflation rates and interest rates. Nonetheless, it has been well documented that such variables little help predict changes in floating exchange rates -- that is, exchange rates follow a random walk. We show that the data do exhibit a related link suggested by standard models ­ that the exchange rate helps predict fundamentals. We also 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 suggest that this may apply to exchange rates. JEL Classification: F310, F370, G150, G120

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Paper provided by European Central Bank in its series Working Paper Series with number 0248.

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Date of creation: Aug 2003
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Handle: RePEc:ecb:ecbwps:20030248
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  1. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
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  4. Ronald Macdonald & Mark P. Taylor, 1993. "The Monetary Approach to the Exchange Rate: Rational Expectations, Long-Run Equilibrium, and Forecasting," IMF Staff Papers, Palgrave Macmillan, vol. 40(1), pages 89-107, March.
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  18. Kenneth D. West, 1986. "Dividend Innovations and Stock Price Volatility," NBER Working Papers 1833, National Bureau of Economic Research, Inc.
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  25. Lars Peter Hansen & Thomas J. Sargent, 1981. "A note on Wiener-Kolmogorov prediction formulas for rational expectations models," Staff Report 69, Federal Reserve Bank of Minneapolis.
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  27. Mussa, Michael, 1976. " The Exchange Rate, the Balance of Payments and Monetary and Fiscal Policy under a Regime of Controlled Floating," Scandinavian Journal of Economics, Wiley Blackwell, vol. 78(2), pages 229-48.
  28. Mark, Nelson C, 1995. "Exchange Rates and Fundamentals: Evidence on Long-Horizon Predictability," American Economic Review, American Economic Association, vol. 85(1), pages 201-18, March.
  29. Chinn, Menzie D. & Meese, Richard A., 1995. "Banking on currency forecasts: How predictable is change in money?," Journal of International Economics, Elsevier, vol. 38(1-2), pages 161-178, February.
  30. Charles Engel & Kenneth D. West, 2004. "Accounting for Exchange Rate Variability in Present-Value Models When the Discount Factor is Near One," NBER Working Papers 10267, National Bureau of Economic Research, Inc.
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