Not So Disconnected: Exchange Rates and the Capital Stock

55 Pages Posted: 30 May 2015 Last revised: 2 Mar 2018

See all articles by Tarek A. Hassan

Tarek A. Hassan

Boston University; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Thomas M. Mertens

Federal Reserve Bank of San Francisco

Tony Zhang

Board of Governors of the Federal Reserve System

Multiple version iconThere are 2 versions of this paper

Date Written: July 22, 2015

Abstract

We investigate the link between stochastic properties of exchange rates and differences in capital-output ratios across industrialized countries. To this end, we endogenize capital accumulation within a standard model of exchange rate determination with nontraded goods. The model predicts that currencies of countries that are more systemic for the world economy (countries that face particularly volatile shocks or account for a large share of world GDP) appreciate when the price of traded goods in word markets is high. These currencies are better hedges against consumption risk faced by international investors because they appreciate in "bad'' states of the world. As a consequence, more systemic countries face a lower cost of capital and accumulate more capital per worker. We estimate our model using data from seven industrialized countries with freely floating exchange rate regimes between 1984-2010 and show that cross-country variation in the stochastic properties of exchange rates accounts for 72% of the cross-country variation in capital-output ratios. In this sense, the stochastic properties of exchange rates map to fundamentals in the way predicted by the model.

Keywords: exchange rate disconnect, capital accumulation, international capital flows, uncovered interest parity

JEL Classification: F3, G0

Suggested Citation

Hassan, Tarek Alexander and Mertens, Thomas M. and Zhang, Tony, Not So Disconnected: Exchange Rates and the Capital Stock (July 22, 2015). Sloan Foundation Economics Research Paper Forthcoming, Fama-Miller Working Paper, Available at SSRN: https://ssrn.com/abstract=2611846 or http://dx.doi.org/10.2139/ssrn.2611846

Tarek Alexander Hassan (Contact Author)

Boston University ( email )

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Boston, MA 02215
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National Bureau of Economic Research (NBER) ( email )

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Centre for Economic Policy Research (CEPR) ( email )

London
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Thomas M. Mertens

Federal Reserve Bank of San Francisco ( email )

101 Market Street
San Francisco, CA 94105
United States

Tony Zhang

Board of Governors of the Federal Reserve System ( email )

20th Street and Constitution Avenue NW
Washington, DC 20551
United States

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