This paper examines the implications of the costs of doing business in foreign countries for the resulting capital market equilibrium. When transferring capital goods across national boundaries is costly we indicate that the costs incurred are quasi-fixed in a one-good, two-country, intertemporal model with complete financial markets. In our model of the international capital market, deviations from purchasing power parity (PPP) are endogenously generated. The relative price of physical resources located in one country compared to resources located in another is called the "real exchange rate."
The outcome of the model-based analysis is an endogenous generation of a mean reverting, real exchange rate in a continuous-time, general equilibrium model of the international capital market. In dynamic equilibrium, the transfer of capital goods between the two countries is found to be infrequent and lumpy in nature as is observed in foreign direct investment.
Recently, Evans and Lothian (1993) have developed an empirical model to uncover the sources of fluctuations in the real dollar exchange rates of major industrial countries. They find that the real exchange rates did not evolve simply in response to permanent shocks. Transitory shocks played a relatively small but statistically significant role. Earlier, Huizinga (1987) documented mean-reversion of commodity prices to their long-run equilibrium value. This implies negative serial correlation in exchange rates in the longer run in contrast to the serially correlated changes implied by a random walk.
Our theoretical model for the real exchange rate is consistent with these empirical findings. As the data indicate, the real exchange rate in our model is influenced by the presence of both temporary and permanent components. Earlier empirical results in Officer (1976), Lee (1976), King (1977), and Cornell (1979) are also reinforced by the analysis in this paper.
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The Cost of Doing Business Abroad and International Capital Market Equilibrium
