The Focus of Productivity in Determining the Long-Term Exchange Rate

This paper examines the behavior of the exchange rate over the long term from the perspective of the purchasing power parity theory (PPP) model developed empirically by Cassel and of the model proposed by Basso originating from the Marxist benchmark, which emphasizes prices and productivities to determine the exchange rate. The consumer price index (IPC), value-added price index and gross producer price index (EU KLEMS database) were used to test the models.The exchange rate behavior is examined for three countries over the 1977-2006 period, with annual frequency, using the causality tests of Granger and of Johansen, the Dickey-Fuller and Phillips-Perron unit root tests, the VAR (vector autoregression) and VEC (vector error correction) models and performing a projection with the Model Confidence Set.Accepting the reasoning of Milton Friedman that a consistent economic theory needs to be capable of performing predictions, we tested the predictive power of the two theories. The most efficient projection models were chosen by the Model Confidence Set.It is ascertained that PPP was only corroborated for one price index and for one pair of countries. Accordingly, we discarded the second step for this theory, namely, the predictive power. In Basso's approach cointegration was found for five models of the United Kingdom-United States country pair, showing the ability to predict the long-term exchange rate, not yet allowing the new model to be generalized for all the pairs of countries