Real Exchange Rates , Preferences , and Incomplete Markets : Evidence , 1961 - 2001

A wide range of international macroeconomic models link the real exchange rate to a ratio of marginal utilities. These include models based on non-traded goods, and those with a variety of frictions including trading costs and pricing to market. We examine this link empirically, while allowing the marginal utility of consumption to depend on government expenditure, leisure, real money balances, or external habit. We also consider two environments with incomplete asset markets; one with exogenously missing markets but an endogenous discount rate that anchors the distribution of wealth and one with endogenous market segmentation. Although none of these satisfies theoretical and over-identifying restrictions for every country, utility with external habit persistence provides the best match with real exchange rates for OECD countries between 1961 and 2001.