The Exchange Rate and Purchasing Power Parity: Extending the Theory and Tests

25 Pages Posted: 4 Jun 2002

See all articles by Prakash Apte

Prakash Apte

Indian Institute of Management, Bangalore

Piet Sercu

FEB at KU Leuven

Raman Uppal

EDHEC Business School; Centre for Economic Policy Research (CEPR)

Date Written: April 2002

Abstract

This Paper analyses the exchange rate in a 'no-arbitrage' or 'real business cycle' equilibrium model and provides empirical evidence for this model vis-a-vis PPP. Our contribution is to show, based on a generalization of the equilibrium model of exchange rates, that (i) the test equation linking the exchange rate to fundamentals should allow for international heterogeneity in time preferences or risk attitudes, as well as noise - that is, the model should not be tested as an exact relation; (ii) empirical work should use levels of variables rather than first differences; (iii) tests on the existence of long-run relations should be complemented by tests on the signs of the coefficients; (iv) the specification of the regression should offer demonstrated advantages over alternatives, and the significance tests should not rely on asymptotic distributions; and (v) the tests should steer clear of countries that have imposed, for most of the period, capital restrictions or exchange controls, thus violating the integrated-markets assumption of the model. Our empirical work shows that, as a long-run relation, the generalized model outperforms PPP.

Keywords: General equilibrium, purchasing power parity, regression tests

JEL Classification: F31

Suggested Citation

Apte, Prakash and Sercu, Piet M. F. A. and Uppal, Raman, The Exchange Rate and Purchasing Power Parity: Extending the Theory and Tests (April 2002). Available at SSRN: https://ssrn.com/abstract=315019

Prakash Apte (Contact Author)

Indian Institute of Management, Bangalore ( email )

Bannerghatta Road
Bangalore, Karnataka
India

Piet M. F. A. Sercu

FEB at KU Leuven ( email )

Naamsestraat 69
Faculty of Economics and Business
Leuven, 3000
Belgium
+32 16 32 67 56 (Phone)
+32 16 32 67 32 (Fax)

Raman Uppal

EDHEC Business School ( email )

58 rue du Port
Lille, 59046
France

Centre for Economic Policy Research (CEPR)

90-98 Goswell Road
London, EC1V 7RR
United Kingdom

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