Exchange Rates and Fundamentals: A Generalization

Federal Reserve Bank of Atlanta Working Paper No. 2008-16

FRB International Finance Discussion Paper No. 948

52 Pages Posted: 2 Jul 2008

See all articles by James M. Nason

James M. Nason

North Carolina State University - Department of Economics

John H. Rogers

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section

Date Written: June 2008

Abstract

Exchange rates have raised the ire of economists for more than twenty years. The problem is that few, if any, exchange rate models are known to systematically beat a naive random walk in out-of-sample forecasts. Engel and West (2005) show that these failures can be explained by the standard present value model (PVM) because it predicts random walk exchange rate dynamics if the discount factor approaches one and fundamentals have a unit root. This paper generalizes the Engel and West hypothesis to the larger class of open economy dynamic stochastic general equilibrium (DSGE) models. The Engel and West hypothesis is shown to hold for a canonical open economy DSGE model. We show that all the predictions of the standard PVM carry over to the DSGE PVM. The DSGE PVM also yields unobserved components (UC) models that we estimate using Bayesian methods and a quarterly Canadian-U.S. sample. Bayesian model evaluation reveals that the data support a UC model that calibrates the discount factor to one, implying the Canadian dollar-U.S. dollar exchange rate is a random walk dominated by permanent cross-country monetary and productivity shocks.

Keywords: exchange rates, present value model and fundamentals, random walk, DSGE model, unobserved components model, Bayesian model comparison

JEL Classification: E31, E37, F41

Suggested Citation

Nason, James M. and Rogers, John H., Exchange Rates and Fundamentals: A Generalization (June 2008). Federal Reserve Bank of Atlanta Working Paper No. 2008-16; FRB International Finance Discussion Paper No. 948. Available at SSRN: https://ssrn.com/abstract=1154154 or http://dx.doi.org/10.2139/ssrn.1154154

James M. Nason (Contact Author)

North Carolina State University - Department of Economics ( email )

Campus Box 8110
NC State University
Raleigh, NC 27695-8110
United States
(919) 513-2884 (Phone)
(919) 515-5613 (Fax)

John H. Rogers

Board of Governors of the Federal Reserve System - Trade and Financial Studies Section ( email )

20th St. and Constitution Ave.
Washington, DC 20551
United States
202-452-2873 (Phone)
202-736-5638 (Fax)

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