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

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.