Working Paper: NBER ID: w10723
Authors: Charles Engel; Kenneth D. West
Abstract: We show analytically that in a rational expectations present value model, an asset price manifests near random walk behavior if fundamentals are I(1) and the factor for discounting future fundamentals is near one. We argue that this result helps explain the well known puzzle that fundamental variables such as relative money supplies, outputs, inflation and interest rates provide little help in predicting changes in floating exchange rates. As well, we show that the data do exhibit a related link suggested by standard models - that the exchange rate helps predict these fundamentals. The implication is that exchange rates and fundamentals are linked in a way that is broadly consistent with asset pricing models of the exchange rate.
Keywords: exchange rates; fundamentals; Granger causality; asset pricing models
JEL Codes: F31; G12; F41; G15
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| fundamentals (Y20) | exchange rates (F31) |
| expected future fundamentals (Q47) | exchange rates (F31) |
| exchange rates (F31) | fundamentals (Y20) |
| exchange rates (F31) | fundamentals (nominal variables) (E19) |