The equilibrium approach to exchange rates: theory and tests
AbstractWe characterize the equilibrium exchange rate in a general equilibrium economy without imposing strong restrictions on the output processes, preferences, or commodity market imperfections. The nomial 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 test of the homothecy/ CRRA version of the model. 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 InfoPaper provided by Katholieke Universiteit Leuven in its series Open Access publications from Katholieke Universiteit Leuven with number urn:hdl:123456789/118567.
Date of creation: 1996
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Equilibrium; Theory; Trade;
Other versions of this item:
- Prakash Apte & Piet Sercu & Raman Uppal, 1996. "The Equilibrium Approach to Exchange Rates: Theory and Tests," NBER Working Papers 5748, National Bureau of Economic Research, Inc.
- F31 - International Economics - - International Finance - - - Foreign Exchange
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