On the Asset Market View of Exchange Rates

Abstract

If the asset market is complete then the difference between foreign and domestic agents' log intertemporal marginal rates of substitution (IMRSs) equals the log change in the real exchange rate. This equation is frequently used to argue that changes in real exchange rates reflect differences between agents' required compensation for exposure to asset return uncertainty. We show that the relative returns on frictionlessly traded assets are only reflected in the common component of agents' IMRSs, not differences. Instead, when this equation does offer insights, frictions in the goods market are the source of economic distinction between agents.