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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

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.

Suggested Citation

  • Chowdhry, Bhagwan & Titman, Sheridan, 1993. "Why Real Interest Rates, Cost of Capital and Price/Earnings Ratios Vary Across Countries," University of California at Los Angeles, Anderson Graduate School of Management qt93k425dd, Anderson Graduate School of Management, UCLA.
  • Handle: RePEc:cdl:anderf:qt93k425dd
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    References listed on IDEAS

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    1. 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.
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    5. 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.
    6. 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.
    7. 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.
    8. 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 153-180.
    9. 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 1024-1040, October.
    10. French, Kenneth R. & Poterba, James M., 1991. "Were Japanese stock prices too high?," Journal of Financial Economics, Elsevier, vol. 29(2), pages 337-363, October.
    11. Mussa, Michael, 1982. "A Model of Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 90(1), pages 74-104, February.
    12. Uppal, Raman, 1993. " A General Equilibrium Model of International Portfolio Choice," Journal of Finance, American Finance Association, vol. 48(2), pages 529-553, June.
    13. Adler, Michael & Lehmann, Bruce, 1983. " Deviations from Purchasing Power Parity in the Long Run," Journal of Finance, American Finance Association, vol. 38(5), pages 1471-1487, December.
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