Exchange Rates and Fundamentals: Closing a Two-Country Model
40 Pages Posted: 9 Sep 2013
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Exchange Rates and Fundamentals: Closing a Two-Country Model
Exchange Rates and Fundamentals: Closing a Two-Country Model
Date Written: September 4, 2013
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 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 counter-factual 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.
Keywords: exchange rates, present-value model, economic fundamentals, random walk, two-country model, incomplete markets, co-integrated TFPs, debt elastic risk premium
JEL Classification: E31, E37, F41
Suggested Citation: Suggested Citation
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