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.

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