This paper by Charles Engel and Kenneth D. West explores the relationship between exchange rates and fundamental variables such as money supplies, outputs, and interest rates. The authors show analytically that in a rational expectations present value model, an asset price exhibits near random walk behavior if the fundamentals are I(1) and the discount factor for future fundamentals is close to one. This helps explain why fundamental variables often fail to predict changes in floating exchange rates. The paper also finds that exchange rates can help predict these fundamentals, suggesting a link between exchange rates and fundamentals that is consistent with asset pricing models. The authors use quarterly data from 1974 to 2001 for the US dollar against six other G7 countries to test these hypotheses. They find some evidence of Granger causality, particularly for nominal variables, indicating that exchange rates can be useful in forecasting fundamentals. The results are consistent with the authors' theoretical framework, which suggests that exchange rate movements are dominated by unobserved shocks that follow a random walk.This paper by Charles Engel and Kenneth D. West explores the relationship between exchange rates and fundamental variables such as money supplies, outputs, and interest rates. The authors show analytically that in a rational expectations present value model, an asset price exhibits near random walk behavior if the fundamentals are I(1) and the discount factor for future fundamentals is close to one. This helps explain why fundamental variables often fail to predict changes in floating exchange rates. The paper also finds that exchange rates can help predict these fundamentals, suggesting a link between exchange rates and fundamentals that is consistent with asset pricing models. The authors use quarterly data from 1974 to 2001 for the US dollar against six other G7 countries to test these hypotheses. They find some evidence of Granger causality, particularly for nominal variables, indicating that exchange rates can be useful in forecasting fundamentals. The results are consistent with the authors' theoretical framework, which suggests that exchange rate movements are dominated by unobserved shocks that follow a random walk.