Takashi KanoBack to index

  • Exchange Rates and Fundamentals: Closing a Two-country Model

    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.

    Introduction

    Few equilibrium models for nominal exchange rates systematically beat a naive randomwalk counterpart in terms of out-of-sample forecast performance. Since the study of Meese and Rogoff (1983), this robust empirical property of nominal exchange rate fluctuations has stubbornly resisted theoretical challenges to understand the behavior of nominal exchange rates as equilibrium outcomes. The recently developed open-economy dynamic stochastic general equilibrium (DSGE) models also suffer from this problem. Infamous as the disconnect puzzle, open-economy DSGE models fail to generate random-walk nominal exchange rates along an equilibrium path because their exchange rate forecasts are closely related to other macroeconomic fundamentals.

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