The Feeble Link between Exchange Rates and Fundamentals: Can We Blame the Discount Factor?

Abstract

Recent research demonstrates that the well-documented feeble link between exchange rates and economic fundamentals can be reconciled with conventional exchange rate theories under the assumption that the discount factor is near unity (Engel and West 2005). We provide empirical evidence that this assumption is valid, lending further support to the above explanation of the empirical disconnect between nominal exchange rates and fundamentals. Copyright (c) 2009 The Ohio State University.

Exchange Rates and Fundamentals: Closing a Two-Country Model

“…This paper's findings of such a low discount factor are in sharp contrast to those of high market discount factors in past empirical studies such as NR, Sarno and Sojli (2009), and BMW. Because these past studies did not jointly consider the endogenous determination of economic fundamentals with nominal exchange rates, the general equilibrium consideration sought by this paper is rele- Appendices not intended for publication…”

“…Examining data on different currencies and spanning distinct sample periods, Sarno and Sojli (2009) and Balke et al (2013, hereafter BMW) identify a 1 Engel (2014) provides the most recent survey on past studies on nominal exchange rates. 2 Nominal exchange rates, therefore, need to Granger-cause future economic fundamentals, not vice versa.…”

Asset Prices and Macroeconomic Outcomes: A Survey

“…Engel and West (2005) show that if fundamentals are integrated of "factor one" and the factor for discounting future fundamentals is near one, then the exchange rate exhibits a behaviour that approximates a random walk. Sarno and Sojli (2009) empirically confirm the assumption of near unity of the discount factor. The results by Engel and West (2005) thus help explain the exchange rate disconnect puzzle since they imply that fundamental variables (such as relative money supplies, output, inflation and interest rates) offer little help in explaining changes in exchange rates.…”

The impact of uncertainty on professional exchange rate forecasts

“…1 Sarno and Sojli (2009) provide evidence that the assumption of a discount factor close to unity is reasonable.…”