The discount factor for expected fundamentals: Evidence from a panel of 25 exchange rates

Abstract

© 2020 CEPII (Centre d'Etudes Prospectives et d'Informations Internationales), a center for research and expertise on the world economy In asset pricing models the exchange rate is the discounted present value of expected economic fundamentals. Engel and West (2005) demonstrate that the well-known weak link between exchange rates and fundamentals, such as money supply, output, inflation and interest rates, is an implication of the model if the discount factor is close to one. Empirical evidence so far is limited. In this paper we estimate the discount factor in the money income model and the Taylor rule model for a large cross-section of 25 currencies, in the period 2001–2018. The results confirm that, on average, the discount factor is indeed close to one, while the estimate is lower for currencies of developing economies and at longer forecast horizons.