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The Equilibrium Approach to Exchange Rates: Theory and Tests

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  • Prakash Apte
  • Piet Sercu
  • Raman Uppal

Abstract

We characterize the equilibrium exchange rate in a general equilibrium economy without imposing strong restrictions on the output processes, preferences, or commodity market imperfections. The nominal exchange rate is determined by differences in initial wealths the currencies of richer countries tend to be overvalued by PPP standards and by differences of marginal indirect utilities of total nominal spending. Changes in the exchange rate mirror differences in growth rates of real spending weighted by relative risk-aversion (which can be time-varying and can differ across countries), and in the case of non-homothetic utility functions, differences in inflation rates computed from marginal spending weights. Thus, standard regression or cointegration tests of PPP suffer from missing-variables biases and ignore variations in risk aversions across countries and over time. We also present cointegration tests of the version of the model with constant relative risk aversion (CRRA) and homothetic preferences. When nominal spending is given an independent role (next to prices) in the short-term dynamics, both PPP and the CRRA model become acceptable.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 5748.

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Date of creation: Sep 1996
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Publication status: published as Apte, Prakash, Piet Sercu and Raman Uppal. "The Exchange Rate And Purchasing Power Parity: Extending The Theory And Tests," Journal of International Money and Finance, 2004, v23(4,Jun), 553-571.
Handle: RePEc:nbr:nberwo:5748

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  1. Ken Froot & Kenneth Rogoff, . "Perspectives on PPP and Long-Run Real Exchange Rates," Working Paper 32027, Harvard University OpenScholar.
  2. Apte, Prakash & Kane, Marian & Sercu, Piet, 1994. "Relative PPP in the medium run," Journal of International Money and Finance, Elsevier, Elsevier, vol. 13(5), pages 602-622, October.
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  4. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, Elsevier, vol. 10(3), pages 335-359.
  5. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, Econometric Society, vol. 55(2), pages 251-76, March.
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  7. Charles Engel, 1990. "On the foreign exchange risk premium in a general equilibrium model," Research Working Paper, Federal Reserve Bank of Kansas City 90-06, Federal Reserve Bank of Kansas City.
  8. Charles Engel, 1990. "The risk premium and the liquidity premium in foreign exchange markets," Research Working Paper, Federal Reserve Bank of Kansas City 90-07, Federal Reserve Bank of Kansas City.
  9. Osterwald-Lenum, Michael, 1992. "A Note with Quantiles of the Asymptotic Distribution of the Maximum Likelihood Cointegration Rank Test Statistics," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, Department of Economics, University of Oxford, vol. 54(3), pages 461-72, August.
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  13. Sercu, Piet & Uppal, Raman & Van Hulle, Cynthia, 1995. " The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity," Journal of Finance, American Finance Association, American Finance Association, vol. 50(4), pages 1309-19, September.
  14. Lewis, Karen K., 1995. "Puzzles in international financial markets," Handbook of International Economics, Elsevier, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 37, pages 1913-1971 Elsevier.
  15. 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, University of Chicago Press, vol. 95(5), pages 1024-40, October.
  16. Stockman, Alan C. & Dellas, Harris, 1989. "International portfolio nondiversification and exchange rate variability," Journal of International Economics, Elsevier, Elsevier, vol. 26(3-4), pages 271-289, May.
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  18. Johansen, Søren & Juselius, Katarina, 1992. "Testing structural hypotheses in a multivariate cointegration analysis of the PPP and the UIP for UK," Journal of Econometrics, Elsevier, Elsevier, vol. 53(1-3), pages 211-244.
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Cited by:
  1. Ng, David T., 2004. "The international CAPM when expected returns are time-varying," Journal of International Money and Finance, Elsevier, Elsevier, vol. 23(2), pages 189-230, March.
  2. Rodolfo Helg & Massimiliano Serati, . "Does the PPP need the UIP?," Working Papers, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University 97, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  3. Rodolfo Helg & Massimiliano Serati, 2000. "The speed of adjustment to PPP: is there any puzzle?," LIUC Papers in Economics, Cattaneo University (LIUC) 74, Cattaneo University (LIUC).

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