Working Paper: NBER ID: w10267
Authors: Charles Engel; Kenneth D. West
Abstract: 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.
Keywords: No keywords provided
JEL Codes: F31; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| observable fundamentals (D80) | exchange rate (F31) |
| discount factor (H43) | exchange rate (F31) |
| unobserved fundamentals (D80) | exchange rate (F31) |