IDEAS home Printed from https://ideas.repec.org/
MyIDEAS: Login to save this article or follow this journal

The Exchange Rate and Purchasing Power Parity in Arbitrage-Free Models of Asset Pricing

  • P. Sercu
Registered author(s):

    Assuming that asset markets are complete and arbitrage-free, the exchange rate can be expressed in terms of observables in a multicountry, multigood general equilibrium economy. In contrast to existing models of the exchange rate, this general model allows for international differences in consumption preferences, time preferences, and the degree of risk aversion, and does not need to specify the imperfections in commodity markets. Changes in the equilibrium exchange rate are given by international differences in: (i) inflation rates computed from marginal spending weights, (ii) growth rates of real spending, weighted by the countries' measures of relative risk-aversion, and (iii) subjective discount rates. The discount rates and risk aversions can vary both over time and across countries. In this general framework, relative Purchasing Power Parity (PPP) holds only if preferences are homothetic and, either (a) investors are risk neutral or (b) commodity markets are perfect and preferences are identical across countries; in all other cases, CPI inflation is only one of the factors determining exchange rate changes. Thus, compared to this general model for exchange rates, standard regression and cointegration tests of PPP suffer from missing-variables biases, errors-in-variables biases, and ignore variations in risk aversions across countries and over time. An attractive feature of this model is that it nests several existing equilibrium models of the exchange rate and also PPP, thus providing a theoretical framework to distinguish empirically between these models. When estimating this equation as a long-run relationship, Sercu and Uppal (2000) and Apte, Sercu and Uppal (2006) find significant evidence against long-run PPP and largely supportive evidence in favor of the more general model.

    If you experience problems downloading a file, check if you have the proper application to view it first. In case of further problems read the IDEAS help page. Note that these files are not on the IDEAS site. Please be patient as the files may be large.

    File URL: http://www.econ.kuleuven.be/tem/jaargangen/2001-2010/2005/TEM%202005-5/TEM_5_05_Sercu.pdf
    Download Restriction: no

    Article provided by Katholieke Universiteit Leuven, Faculteit Economie en Bedrijfswetenschappen in its journal Review of Business and Economics.

    Volume (Year): L (2005)
    Issue (Month): 5 ()
    Pages: 825-854

    as
    in new window

    Handle: RePEc:ete:revbec:20050507
    Contact details of provider: Postal: Naamsestraat 69, 3000 Leuven
    Web page: http://www.econ.kuleuven.be

    More information through EDIRC

    No references listed on IDEAS
    You can help add them by filling out this form.

    This item is not listed on Wikipedia, on a reading list or among the top items on IDEAS.

    When requesting a correction, please mention this item's handle: RePEc:ete:revbec:20050507. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Hilde Roos)

    The email address of this maintainer does not seem to be valid anymore. Please ask Hilde Roos to update the entry or send us the correct address

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If references are entirely missing, you can add them using this form.

    If the full references list an item that is present in RePEc, but the system did not link to it, you can help with this form.

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    This information is provided to you by IDEAS at the Research Division of the Federal Reserve Bank of St. Louis using RePEc data.