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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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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. Martin Boileau & Michel Normandin, 2005. "Closing International Real Business Cycle Models with Restricted Financial Markets," Cahiers de recherche 0506, CIRPEE.
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  19. 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.
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