The Equilibrium Approach to Exchange Rates: Theory and Tests

44 Pages Posted: 7 Nov 1996 Last revised: 4 Oct 2010

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: September 1996

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.

Suggested Citation

Apte, Prakash and Sercu, Piet M. F. A. and Uppal, Raman, The Equilibrium Approach to Exchange Rates: Theory and Tests (September 1996). NBER Working Paper No. w5748, Available at SSRN: https://ssrn.com/abstract=4403

Prakash Apte

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 (Contact Author)

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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