Exchange Rates and Fundamentals: A General Equilibrium Exploration

Takashi Kano and 隆 加納

No HIAS-E-19, Discussion paper series from Hitotsubashi Institute for Advanced Study, Hitotsubashi University

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.

Keywords: Exchange rate; Present-value model; Economic fundamental; Random walk; Two-country model; Incomplete market; Cointegrated TFPs; Perfect risk sharing (search for similar items in EconPapers)
JEL-codes: E31 E37 F41 (search for similar items in EconPapers)
Pages: 28 pages
Date: 2019-04
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac and nep-opm
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
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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