TY  - JOUR
AU  - Engel,Charles
AU  - West,Kenneth D.
TI  - Accounting for Exchange Rate Variability in Present-Value Models When the Discount Factor is Near One
JF  - National Bureau of Economic Research Working Paper Series
VL  - No. 10267
PY  - 2004
Y2  - February 2004
UR  - http://www.nber.org/papers/w10267
L1  - http://www.nber.org/papers/w10267.pdf
N1  - Author contact info:
Charles Engel
Department of Economics
University of Wisconsin
1180 Observatory Drive
Madison, WI  53706-1393
Tel: 608/262-3697
Fax: 608/262-2033
E-Mail: cengel@ssc.wisc.edu

Kenneth D. West
Department of Economics
University of Wisconsin
1180 Observatory Drive
Madison, WI  53706
Tel: 608/262-0033
Fax: 608/262-2033
E-Mail: kdwest@wisc.edu
AB  - 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.
ER  -