Exchange Rates and Fundamentals: Closing a Two-country Model

Takashi Kano

CAMA Working Papers from Centre for Applied Macroeconomic Analysis, Crawford School of Public Policy, The Australian National University

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 counterfactual 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; Cointegrated TFPs; Debt elastic risk premium (search for similar items in EconPapers)
JEL-codes: E31 E37 F41 (search for similar items in EconPapers)
Pages: 40 pages
Date: 2013-09
New Economics Papers: this item is included in nep-opm
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Related works:
Working Paper: Exchange Rates and Fundamentals: Closing a Two-country Model (2014)
Working Paper: Exchange Rates and Fundamentals:Closing a Two-country Model (2013)
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Persistent link: https://EconPapers.repec.org/RePEc:een:camaaa:2013-62

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