Exchange Rates and Fundamentals: A General Equilibrium Exploration

Engel and West (2005) show that the observed near random-walk behavior of nominal exchange rates is an equilibrium outcome of a partial equilibrium asset approach when economic fundamentals follow exogenous first-order integrated processes and the discount factor approaches one. In this paper, I argue that the unit market discount factor creates a theoretical trade-off within a two-country general equilibrium model. The unit discount factor generates near random-walk nominal exchange rates, but it counterfactually implies perfect consumption risk sharing and flat money demand. Bayesian posterior simulation exercises, based on post-Bretton Woods data from Canada and the United States, reveal difficulties in reconciling the equilibrium random-walk proposition within the canonical model; in particular, the market discount factor is identified as being much smaller than one. A relative money demand shock is identified as the main driver of nominal exchange rates.