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The Equilibrium Approach to Exchange Rates: Theory and Tests

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Author Info
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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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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Handle: RePEc:nbr:nberwo:5748

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F31 - International Economics - - International Finance - - - Foreign Exchange

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  1. 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, vol. 53(1-3), pages 211-244. [Downloadable!] (restricted)
  2. Apte, Prakash & Kane, Marian & Sercu, Piet, 1994. "Relative PPP in the medium run," Journal of International Money and Finance, Elsevier, vol. 13(5), pages 602-622, October. [Downloadable!] (restricted)
  3. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359. [Downloadable!] (restricted)
  4. Svensson, Lars E O, 1985. "Money and Asset Prices in a Cash-in-Advance Economy," Journal of Political Economy, University of Chicago Press, vol. 93(5), pages 919-44, October. [Downloadable!] (restricted)
  5. Backus, David K. & Smith, Gregor W., 1993. "Consumption and real exchange rates in dynamic economies with non-traded goods," Journal of International Economics, Elsevier, vol. 35(3-4), pages 297-316, November. [Downloadable!] (restricted)
  6. Lewis, Karen K., 1995. "Puzzles in international financial markets," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 37, pages 1913-1971 Elsevier. [Downloadable!] (restricted)
  7. Johansen, Soren & Juselius, Katarina, 1990. "Maximum Likelihood Estimation and Inference on Cointegration--With Applications to the Demand for Money," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 52(2), pages 169-210, May.
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  9. 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, vol. 50(4), pages 1309-19, September. [Downloadable!] (restricted)
  10. 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. [Downloadable!] (restricted)
  11. Kenneth A. Froot & Kenneth Rogoff, 1996. "Perspectives on PPP and Long-Run Real Exchange Rates," NBER Working Papers 4952, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
  12. Stockman, Alan C, 1980. "A Theory of Exchange Rate Determination," Journal of Political Economy, University of Chicago Press, vol. 88(4), pages 673-98, August. [Downloadable!] (restricted)
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  13. Engle, Robert F & Granger, Clive W J, 1987. "Co-integration and Error Correction: Representation, Estimation, and Testing," Econometrica, Econometric Society, vol. 55(2), pages 251-76, March. [Downloadable!] (restricted)
  14. Granger, C. W. J., 1981. "Some properties of time series data and their use in econometric model specification," Journal of Econometrics, Elsevier, vol. 16(1), pages 121-130, May. [Downloadable!] (restricted)
  15. Singleton, Kenneth J., 1990. "Specification and estimation of intertemporal asset pricing models," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 1, chapter 12, pages 583-626 Elsevier. [Downloadable!] (restricted)
  16. Charles Engel, 1990. "On the foreign exchange risk premium in a general equilibrium model," Research Working Paper 90-06, Federal Reserve Bank of Kansas City.
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  17. Phillips, P C B, 1991. "Optimal Inference in Cointegrated Systems," Econometrica, Econometric Society, vol. 59(2), pages 283-306, March. [Downloadable!] (restricted)
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  18. Dickey, David A & Rossana, Robert J, 1994. "Cointegrated Time Series: A Guide to Estimation and Hypothesis Testing," Oxford Bulletin of Economics and Statistics, Department of Economics, University of Oxford, vol. 56(3), pages 325-53, August.
  19. Domowitz, Ian & Hakkio, Craig S., 1985. "Conditional variance and the risk premium in the foreign exchange market," Journal of International Economics, Elsevier, vol. 19(1-2), pages 47-66, August. [Downloadable!] (restricted)
  20. Johansen, Soren, 1991. "Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models," Econometrica, Econometric Society, vol. 59(6), pages 1551-80, November. [Downloadable!] (restricted)
  21. Dumas, Bernard, 1992. "Dynamic Equilibrium and the Real Exchange Rate in a Spatially Separated World," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 5(2), pages 153-80. [Downloadable!] (restricted)
  22. Engel, Charles, 1992. "The Risk Premium and the Liquidity Premium in Foreign Exchange Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 33(4), pages 871-79, November. [Downloadable!] (restricted)
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  23. 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. [Downloadable!] (restricted)
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Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Rodolfo Helg & Massimiliano Serati, 2000. "The speed of adjustment to PPP: is there any puzzle?," LIUC Papers in Economics 74, Cattaneo University (LIUC). [Downloadable!]
  2. Rodolfo Helg & Massimiliano Serati, . "Does the PPP need the UIP?," Working Papers 97, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University. [Downloadable!]
    Other versions:
  3. Giuseppe Cavaliere & Luca Fanelli & Attilio Gardini, 2006. "International dynamic risk sharing," Quaderni di Dipartimento 1, Department of Statistics, University of Bologna. [Downloadable!]
    Other versions:
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