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

Extending the Theory and Tests This paper analyzes the exchange rate in a "no-arbitrage " or "real business cycle " equilib-rium 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 het-erogeneity 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 comple-mented by tests on the signs of the coefficients; (i v) 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 violat-ing the integrated-markets assumption of the model. Our empirical work shows that, as a long-run relation, the generalized model outperforms PPP. JEL classification: F3