Working Paper: NBER ID: w5748
Authors: Prakash Apte; Piet Sercu; Raman Uppal
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.
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Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| initial wealth differences (D31) | nominal exchange rate (F31) |
| marginal indirect utilities of nominal spending (D11) | nominal exchange rate (F31) |
| nominal exchange rate (F31) | overvalued currencies by PPP standards (F31) |
| growth rates of real spending (E20) | nominal exchange rate (F31) |
| risk aversion (D81) | nominal exchange rate (F31) |
| nominal spending (H61) | nominal exchange rate (F31) |
| missing variables (C39) | bias in causal inference of exchange rate models (F31) |