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Exchange Rates and Fundamentals: Closing a Two-country Model

  • Kano, Takashi

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.

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File URL: http://hermes-ir.lib.hit-u.ac.jp/rs/bitstream/10086/25834/1/070econDP13-07.pdf
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Paper provided by Graduate School of Economics, Hitotsubashi University in its series Discussion Papers with number 2013-07.

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Length: 40, [8] p.
Date of creation: 03 Aug 2014
Date of revision:
Handle: RePEc:hit:econdp:2013-07
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  2. James M. Nason & John H. Rogers, 2003. "The present-value model of the current account has been rejected: round up the usual suspects," International Finance Discussion Papers 760, Board of Governors of the Federal Reserve System (U.S.).
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  8. 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.
  9. Takashi Kano & Hafedh Bouakez, 2005. "Learning-by-doing or Habit Formation?," Computing in Economics and Finance 2005 126, Society for Computational Economics.
  10. International Monetary Fund, 2010. "Investment; Specific Technology Shocks and International Business Cycles: An Empirical Assessment," IMF Working Papers 10/207, International Monetary Fund.
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  19. John Geweke, 1998. "Using simulation methods for Bayesian econometric models: inference, development, and communication," Staff Report 249, Federal Reserve Bank of Minneapolis.
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