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Why Real Interest Rates, Cost of Capital and Price/Earnings Ratios Vary Across Countries

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  • Chowdhry, Bhagwan
  • Titman, Sheridan
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    Abstract

    This paper examines how productivity changes affect real rates of return and price/earnings ratios in a small open economy. The model provides conditions under which increased productivity in a country’s traded goods sector causes prices of non-traded goods to increase relative to the price of traded goods. Under these conditions, real rates of interest decline and the production of certain non-traded durable goods (such as capital equipment and housing) immediately increase. This ‘overconstruction’ has two effects. First, the increase in capital relative to labor in these sectors increases the marginal product of labor and hence immediately causes an increase in wages and the prices of non-traded goods. Second, an ‘oversupply’ of capital goods and housing depresses their rental rates in the current period, thereby increasing their price to rental ratios or equivalently, their price/earnings ratios.

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    Bibliographic Info

    Paper provided by Anderson Graduate School of Management, UCLA in its series University of California at Los Angeles, Anderson Graduate School of Management with number qt93k425dd.

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    Date of creation: 01 Jan 1993
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    Handle: RePEc:cdl:anderf:qt93k425dd

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    1. Stulz, Rene M, 1987. "An Equilibrium Model of Exchange Rate Determination and Asset Pricing with Nontraded Goods and Imperfect Information," Journal of Political Economy, University of Chicago Press, vol. 95(5), pages 1024-40, October.
    2. Hsieh, David A., 1982. "The determination of the real exchange rate : The productivity approach," Journal of International Economics, Elsevier, vol. 12(3-4), pages 355-362, May.
    3. Adler, Michael & Lehmann, Bruce, 1983. " Deviations from Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 38(5), pages 1471-87, December.
    4. Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 153-80.
    5. R. C. Merton, 1970. "Optimum Consumption and Portfolio Rules in a Continuous-time Model," Working papers 58, Massachusetts Institute of Technology (MIT), Department of Economics.
    6. Solnik, Bruno H., 1974. "An equilibrium model of the international capital market," Journal of Economic Theory, Elsevier, vol. 8(4), pages 500-524, August.
    7. Stockman, Alan C. & Dellas, Harris, 1989. "International portfolio nondiversification and exchange rate variability," Journal of International Economics, Elsevier, vol. 26(3-4), pages 271-289, May.
    8. French, K.R. & Poterba, J.M., 1990. "Are Japanese Stock Prices Too High?," Working papers 547, Massachusetts Institute of Technology (MIT), Department of Economics.
    9. David Meerschwam, 1991. "The Japanese Financial System and the Cost of Capital," NBER Chapters, in: Trade with Japan: Has the Door Opened Wider?, pages 191-224 National Bureau of Economic Research, Inc.
    10. Mussa, Michael, 1982. "A Model of Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 90(1), pages 74-104, February.
    11. Uppal, Raman, 1993. " A General Equilibrium Model of International Portfolio Choice," Journal of Finance, American Finance Association, vol. 48(2), pages 529-53, June.
    12. Lawrence H. Officer, 1982. "The Purchasing-Power-Parity Theory of Gerrard de Malynes," History of Political Economy, Duke University Press, vol. 14(2), pages 256-259, Summer.
    13. Bela Balassa, 1964. "The Purchasing-Power Parity Doctrine: A Reappraisal," Journal of Political Economy, University of Chicago Press, vol. 72, pages 584.
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