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The feeble link between exchange rates and fundamentals: can we blame the discount factor?

Article Excerpt
The feeble link between nominal exchange rates and economic fundamentals, often termed the "exchange rate disconnect puzzle," is a stylized fact documented with remarkable robustness in empirical research (Meese and Rogoff 1983, Mark 1995, Cheung, Chinn, and Pascual 2005, Sarno 2005). However, Engel and West (2005, hereafter EW) demonstrate that the puzzling disconnect between exchange rates and fundamentals can be reconciled with exchange rate theories using a stylized rational expectations model, where the exchange rate equals the discounted present value of expected economic fundamentals. Their result hinges upon two assumptions: (i) fundamentals are nonstationary (or near-random walk) processes, and (ii) the factor for discounting expected fundamentals in the exchange rate equation is relatively large, e.g., smaller than unity but greater than 0.9.

Under the above conditions, the EW model replicates the stylized facts on the relation between exchange rates and fundamentals, changing the interpretation of the weak link between them, which has often been viewed as a rejection of conventional exchange rate determination theories. This framework shows that the empirical disconnect between exchange rates and fundamentals is exactly what these theories imply under assumptions (i) and (ii). Assumption (i) is uncontroversial in the literature in that fundamentals are generally found to be nonstationary processes (e.g., EW, Engel, Mark, and West 2007). However, assumption (ii) has not been tested, to the best of our knowledge. Therefore, a test of this assumption is important to shed light on whether the solution to the exchange rate disconnect puzzle offered by EW is likely to have empirical relevance, l We test and find evidence supporting assumption (ii) by using expectations data on four major currency pairs.

1. EMPIRICAL IMPLEMENTATION

The exchange rate can be written as the discounted present value of expected fundamentals:

[s.sub.t] = (1 - b) [[infinity].summation over (j=0)][b.sup.j][E.sub.t][f.sub.t+j], (1)

where s, is the log nominal exchange rate (domestic price of the foreign currency) at time t, [f.sub.t+j] is the log fundamentals term at time t + j, < b < 1 is the discount factor, and E is the mathematical expectation operator. Equation (1) is the rational expectations solution to a variety of models that postulate...

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