The Equilibrium Approach to Exchange Rates: Theory and Tests

Prakash Apte, Piet Sercu and Raman Uppal

No 5748, NBER Working Papers from National Bureau of Economic Research, Inc

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.

JEL-codes: F31 (search for similar items in EconPapers)
Date: 1996-09
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Citations: View citations in EconPapers (5)

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.

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