Accounting for Exchange Rate Variability in Present-Value Models When the Discount Factor is Near One / Charles Engel, Kenneth D. West.

Format:

Book

Author/Creator:

Engel, Charles.

Contributor:

National Bureau of Economic Research.

West, Kenneth D.

Series:

Working Paper Series (National Bureau of Economic Research) no. w10267.

NBER working paper series no. w10267

Language:

English

Physical Description:

1 online resource: illustrations (black and white);

Place of Publication:

Cambridge, Mass. National Bureau of Economic Research 2004.

Summary:

Nominal exchange rates in low-inflation advanced countries are nearly random walks. Engel and West (2003a) offer an explanation for this in the context of models in which the exchange rate is determined as the discounted sum of current and expected future fundamentals. Engel and West show that if the fundamentals are I(1), then as the discount factor approaches one, the exchange rate becomes indistinguishable from a random walk. An alternative explanation for the random-walk behavior of exchange rates is that there are some unobserved variables that drive exchange rates that follow near random walks. This paper takes the approach that both explanations are possible. We are able to measure how much of exchange-rate variation could be accounted for by the Engel-West explanation, despite the fact that we do not observe the information set of financial markets. We find that the observable fundamentals (money, income, prices, interest rates) may account for about 40 percent of the variance of changes in exchange rates under the assumption of discount factors near unity.

Notes:

Print version record

February 2004.