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Exchange Rates and Fundamentals: Closing a Two-country Model

  • Takashi Kano

In an influential paper, Engel and West (2005) claim that the near random-walk behavior of nominal exchange rates is an equilibrium outcome of a variant of present-value models when economic fundamentals follow exogenous first-order integrated processes and the discount factor approaches one. Subsequent empirical studies further confirm this proposition by estimating a discount factor that is close to one under distinct identification schemes. In this paper, I argue that the unit market discount factor implies the counterfactual joint equilibrium dynamics of random-walk exchange rates and economic fundamentals within a canonical, two-country, incomplete market model. Bayesian posterior simulation exercises of a two-country model based on post-Bretton Woods data from Canada and the United States reveal difficulties in reconciling the equilibrium random-walk proposition within the two-country model; in particular, the market discount factor is identified as being much lower than one.

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File URL: https://cama.crawford.anu.edu.au/sites/default/files/publication/cama_crawford_anu_edu_au/2013-09/62_2013_kano.pdf
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Paper provided by Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University in its series CAMA Working Papers with number 2013-62.

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Length: 40 pages
Date of creation: Sep 2013
Date of revision:
Handle: RePEc:een:camaaa:2013-62
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  1. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Closing Small Open Economy Models," Departmental Working Papers 200115, Rutgers University, Department of Economics.
  2. John Geweke, 1998. "Using simulation methods for Bayesian econometric models: inference, development, and communication," Staff Report 249, Federal Reserve Bank of Minneapolis.
  3. Engel, Charles & West, Kenneth D., 2003. "Exchange rates and fundamentals," Working Paper Series 0248, European Central Bank.
  4. Gianluca Benigno & Christoph Thoenissen, 2004. " Consumption and Real Exchange Rates with Incomplete Markets and Non-traded Goods," CDMA Conference Paper Series 0405, Centre for Dynamic Macroeconomic Analysis, revised Dec 2006.
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  16. Ghironi, Fabio, 2006. "Macroeconomic interdependence under incomplete markets," Journal of International Economics, Elsevier, vol. 70(2), pages 428-450, December.
  17. Alejandro Justiniano & Bruce Preston, 2010. "Monetary policy and uncertainty in an empirical small open-economy model," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 25(1), pages 93-128.
  18. Lucio Sarno & Elvira Sojli, 2009. "The Feeble Link between Exchange Rates and Fundamentals: Can We Blame the Discount Factor?," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(2-3), pages 437-442, 03.
  19. Bodenstein, Martin, 2011. "Closing large open economy models," Journal of International Economics, Elsevier, vol. 84(2), pages 160-177, July.
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