## Accounting for Exchange Rate Variability in Present-value Models when the Discount Factor is Near One, Issue 10267Nominal 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. |

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1050 Massachusetts Avenue ACCOUNTING FOR EXCHANGE Andrei Shleifer behavior of exchange Bureau of Economic Charles Engel Kenneth Chinn cointegration corr-s current and expected current and lagged Department of Economics discount factor approaches discounted sum driving exchange rates econometrician economic fundamentals Engel and West equation estimates EW theorem Exchange Rate Models EXCHANGE RATE VARIABILITY expected future fundamentals Foreign Exchange Market Germany 0.9 information set inside the back instructions inside interest semi-elasticity Italy Journal of International Kenneth Rogoff lagged fundamentals lagged values list To subscribe Macroeconomics Mark Watson mean Meese models of exchange monetary model monetary policy money demand errors money supplies National Bureau NBER Working Papers Nominal Exchange Rates observed fundamentals OECD papers in hard PRESENT-VALUE MODELS random walk Rates and Fundamentals Ratio Canada 0.9 risk premium single area sum of current Summary Statistics Taylor-rule model U.S. bank University of Wisconsin unobserved var(As VARIABILITY IN PRESENT-VALUE variance of Ax