DEVIATIONS FROM PURCHASING POWER PARITY AND CAPITAL FLOWS

This article examines the implications of deviations from purchasing power parity (PPP) for an investor's portfolio decision and the consequent capital flows, in a two-country, intertemporal model with complete financial markets. In the presence of deviations from PPP, investors from different nations hold disparate portfolios and the equilibrium that results is not a pooling one. We solve explicitly for asset demands and derive the relationship between the direction of capital flows and deviations from PPP. In contrast to the small country assumption in the existing literature, the world interest rate in this model is determined endogenously.