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Exchange Rates and Fundamentals: Closing a Two-country Model

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  • Kano, Takashi

Abstract

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 present-value model of a partial equilibrium asset approach 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 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.

Suggested Citation

  • Kano, Takashi, 2014. "Exchange Rates and Fundamentals: Closing a Two-country Model," Discussion Papers 2013-07, Graduate School of Economics, Hitotsubashi University.
  • Handle: RePEc:hit:econdp:2013-07
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    References listed on IDEAS

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    Cited by:

    1. Kano, Takashi & Morita, Hiroshi, 2015. "An equilibrium foundation of the Soros chart," Journal of the Japanese and International Economies, Elsevier, vol. 37(C), pages 21-42.
    2. Anella Munro, 2015. "Exchange rates, expected returns and risk: what can we learn from Asia-Pacific currencies?," BIS Papers chapters,in: Bank for International Settlements (ed.), Cross-border Financial Linkages: Challenges for Monetary Policy and Financial Stability, volume 82, pages 137-166 Bank for International Settlements.
    3. Daan Steenkamp, 2017. "How bubbly is the New Zealand dollar?," Reserve Bank of New Zealand Discussion Paper Series DP2017/03, Reserve Bank of New Zealand.
    4. Anella Munro, 2014. "Exchange rates, expected returns and risk," Reserve Bank of New Zealand Discussion Paper Series DP2014/01, Reserve Bank of New Zealand.

    More about this item

    Keywords

    Exchange rates; Present-value model; Economic fundamentals; Random walk; Two- country model; Incomplete markets; Cointegrated TFPs; Debt elastic risk premium; Backus-Smith puzzle;

    JEL classification:

    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E37 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Forecasting and Simulation: Models and Applications
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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