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Exchange Rates and Fundamentals: A General Equilibrium Exploration

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  • KANO, Takashi

Abstract

Engel and West (2005) claim that the observed 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 discount factors close to one under distinct identification schemes. In this paper, I argue that the unit market discount factor creates a theoretical trade-off within a neoclassical, two-country, incomplete-market monetary model; on the one hand, the unit discount factor generates near random-walk nominal exchange rates, while, on the other hand, it counterfactually implies perfect consumption risk sharing as well as 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.

Suggested Citation

  • KANO, Takashi, 2016. "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
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    File URL: http://hermes-ir.lib.hit-u.ac.jp/rs/bitstream/10086/27738/1/070_hiasDP-E-19.pdf
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    References listed on IDEAS

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    Cited by:

    1. KANO, Takashi, 2016. "Trend Inflation and Exchange Rate Dynamics : A New Keynesian Approach," Discussion paper series HIAS-E-38, Hitotsubashi Institute for Advanced Study, Hitotsubashi University.

    More about this item

    Keywords

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

    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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