The Exchange Rate in the Presence of Transaction Costs: Implications for Tests of Purchasing Power Parity





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    • Financial support from the Center for International Business Studies at University of British Columbia, the Social Sciences and Humanities Research Council of Canada, and the European Institute for Advanced Studies in Management is gratefully acknowledged. We are also grateful to Filip Abraham, Reena Aggarwal, Uri Ben-Zion, Paul De Grauwe, Harris Delias, Glen Donaldson, Rob Heinkel, Burton Hollifield, Maurice Levi, Vasant Naik, and Richard Stehle for comments. We would also like to thank the editor, René Stulz, for his suggestions, and the referee for an insightful comment that allowed us to simplify the derivation of our results considerably.


With transaction costs for trading goods, the nominal exchange rate moves within a band around the nominal purchasing power parity (PPP) value. We model the behavior of the band and of the exchange rate within the band. The model explains why there are below-unity slope coefficients in regression tests of PPP, and why these increase toward unity under hyperinflation or with low-frequency data. Our results are independent of the presence of nontraded goods in the economy.