Exchange rates and fundamentals: A generalization

Arbeitspapier

Exchange rates have raised the ire of economists for more than 20 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 (EW) hypothesis to the larger class of open economy dynamic stochastic general equilibrium (DSGE) models. The EW 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 an 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.

Object Details

• Language: Englisch

References and Relationships

• Bibliographic citation: Series: Working Paper ; No. 2008-16

Classification and Topics

• Classification: Wirtschaft ; Price Level; Inflation; Deflation ; Prices, Business Fluctuations, and Cycles: Forecasting and Simulation: Models and Applications ; Open Economy Macroeconomics
• Subject: exchange rates ; present value model and fundamentals ; random walk ; DSGE model ; unobserved components model ; Bayesian model comparison

Contributors, Places and Time

• Event: Geistige Schöpfung
• (who): Nason, James M. ; Rogers, John H.
• Event: Veröffentlichung
• (who): Federal Reserve Bank of Atlanta
• (where): Atlanta, GA
• (when): 2008

Further information

• Handle: http://hdl.handle.net/10419/70705
• Last update: 10.03.2025, 11:44 AM CET