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Exchange Rates and Fundamentals: A General Equilibrium Exploration

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  • Kano, Takashi
  • 加納, 隆

Abstract

Engel and West (2005) show that the observed near random-walk behavior of nominal exchange rates is an equilibrium outcome of a partial equilibrium asset approach when economic fundamentals follow exogenous first-order integrated processes and the discount factor approaches one. In this paper, I argue that the unit market discount factor creates a theoretical trade-off within a two-country general equilibrium model. The unit discount factor generates near random-walk nominal exchange rates, but it counterfactually implies perfect consumption risk sharing and flat money demand. 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 canonical model; in particular, the market discount factor is identified as being much smaller than one. A relative money demand shock is identified as the main driver of nominal exchange rates.

Suggested Citation

  • Kano, Takashi & 加納, 隆, 2019. "Exchange Rates and Fundamentals: A General Equilibrium Exploration," Discussion paper series HIAS-E-19, Hitotsubashi Institute for Advanced Study, Hitotsubashi University.
  • Handle: RePEc:hit:hiasdp:hias-e-19
    Note: Current Draft: April 15, 2019, This is a revised version of a paper previously circulated under the title of “Exchange Rates and Fundamentals: Closing a Two-country Model.”, Includes Online Appendix
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    More about this item

    Keywords

    Exchange rate; Present-value model; Economic fundamental; Random walk; Two-country model; Incomplete market; Cointegrated TFPs; Perfect risk sharing;
    All these keywords.

    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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