Chapter 6 Purchasing Power Parity Theory and Floating Exchange Rate Experience

PPP Theory and the Law of One price

The basic concept underlying PPP theory is that arbitrage forces will lead to the equalisation of goods prices internationally, once the prices of goods are measured in the same currency.

The Law of One Price

The law of one price simply states that in the presence of a competitive market structure and the absence of transport costs and other barriers to trade, identical products which are sold in different markets will sell at the same price when expressed in terms of a common currency. The law of one price is based on the idea of perfect goods arbitrage. Arbitrage occurs where economic agents exploit price differences so as to provide a riskless profit.

Example on page 126

The proponents of PPP argue that the exchange rate must adjust to ensure that the law of one price, which applies only to individual goods, also holds internationally for identical bundles of goods.

Absolute and Relative PPP

A Generalised Version of PPP

One of the major problems with PPP theory is that it suggests that PPP holds for all types of goods. A more generalised version of PPP, however, provides some useful insights by making a distinction between traded and non-traded goods. Traded goods are susceptible to the rigours of international competition export or import-competing industries such as most manufactured goods. Non-traded goods are those that cannot be traded internationally at a profit such as houses and certain services such as a haircut or restaurant food. The point of the traded/non-traded goods distinction is that on a priori grounds PPP is more likely to hold for traded than for non-traded goods. This is because the price of traded goods will tend to be kept in line by international competition while the price of non-traded goods will be determined predominately by domestic supply and demand considerations.

Example on page 128

Equation (6.8) is an important modification to our simple PPP equation because PPP no longer necessarily holds in terms of aggregate price indices due to the multiplicative term on the right-hand side. The equation also suggests that the relative price of non-tradables relative to tradables will influence the exchange rate. If the domestic price of non-tradables rises relative to tradables, this will lead to an appreciation (fall) of the home currency. The reason is that PPP holds only in terms of tradable goods. A rise in the relative price of non-tradables, while keeping the aggregate price index constant, implies that the price of tradables must have fallen, which will then induce an appreciation of the exchange to maintain PPP for tradeable goods even though the aggregate price index has remained unchanged. A rise in the price of tradables, while holding the aggregate price index constant, leads to a depreciation of the exchange rate to maintain PPP for tradeable goods.

Exchange rate movements induced by changes in the relative prices between tradable and non-tradable goods represent real exchange rate changes.

Measurement Problems in Testing for PPP

1. To decide whether or not the theory is supposed to be applicable to both traded and non-traded goods, or applicable to only one of those categories. If the theory is supposed to be applicable to traded goods only, then the price index used for testing the theory needs to be made up only of traded goods. If the theory is applicable to both traded and non-traded goods, then a more general price index should be employed.

Whichever price index researchers decide to employ, the PPP is only expected to hold for similar baskets of goods but national price indices typically attach different weights to different classes of goods. Consumer price indices which weight both classes of goods are generally used.

2. The base period for the test should ideally be one where PPP holds approximately There are divergences of view over the time span during which PPP can be expected to assert itself.

Empirical Evidence of PPP

Pp. 130 140

Explaining the Poor Performance of PPP Theory

1. Statistical problems PPP is based upon the concept of comparing identical baskets of goods in two economies. Different countries, however, usually attach different weights to various categories of goods and services when constructing their price indices which makes comparison difficult when testing for PPP. This factor is likely to be significant when testing for PPP between developed and developing countries.

2. Transport costs and trade impediments Frenkel (1981) notes that PPP holds better when the countries concerned are geographically close and trade linkages are high.

3. Imperfect competition One of the notions underlying PPP is that there is sufficient international competition to prevent major departures of the price of a good in one country exceeding that in another. However, it is clear that there are considerable variations in the degree of competition internationally; these differences mean that multinational corporations can often get away with charging different prices in different countries for the same product or service price discrimination.

4. Differences between capital and goods market PPP is based upon the concept of goods arbitrage and has nothing to say about the role of capital movements. Rudiger Dornbusch (1976) hypothesised that, in a world where capital markets are highly integrated and goods markets exhibit slow price adjustment, there can be substantial prolonged deviation of the exchange rate from PPP. In the short run, goods prices in both home and foreign economies can be considered as fixed, while the exchange rate adjusts quickly to new information and changes in economic policy. Exchange rate changes represent deviations from PPP.

5. Productivity differentials When prices of similar baskets of both traded and non-traded goods are converted into a common currency, the aggregate price indices tend to be higher in rich countries than in poor countries. The overall higher price index in rich countries is mainly due to the fact that non-tradable goods prices are higher in developed than developing countries. Bela Balassa (1964) and Paul Samuelson (1964) put forward that the lower price of goods in the non-traded sector in developing counties is mainly due to lower labour productivity in the tradeables sector compared to developed countries. The higher price of non-traded goods in a developed nation, compared to a developing country, is due to higher labour productivity in the traded sector compared to labour productivity in the tradeable sector of developing countries.

The Balassa-Samuelson Model (not covered in lecture)

Pp. 141 143

Per Capita Income Levels, The Relative Sizes of Economies and the Importance of PPP Estimates

Pp. 143 - 144

Exchange rates of developing countries tend to be noticeably undervalued in terms of purchasing power for goods and services. The GDP per capita based on PPP is a more reliable guide to relative living standard in two countries than using the market exchange rate which does not reflect PPP. PPP adjustments make a significant different to GDP per capita estimates, and they also make a big difference to the importance of the relative size of different economies.

Covered Interest Rate Parity The Determination of the Forward Exchange Rate

The forward exchange market is where buyers and sellers agree to exchange currencies at some specified date in the future.

Hedgers

Hedgers are agents (usually firms) that enter the forward exchange market to protect themselves against exchange rate fluctuations which entail exchange rate risk. Exchange risk is the risk of loss due to adverse exchange rate movements.

Example on page 25

Hedgers avoid exchange risk by matching their assets and liabilities in the foreign currency.

Arbitrage

Arbitrageurs are agents (usually banks) that aim to make a riskless profit out of discrepancies between interest rate differentials and what is known as the forward discount or forward premium. A currency is said to be at a forward premium (discount) if the forward exchange rate quotation for that currency represents an appreciation (depreciation) for that currency compared to the spot quotation.

The forward discount or premium is usually expressed as a percentage of the spot exchange rate:

Table 1.1 on page 26

Numerical Example on pages 26 27

Speculators

Speculators are agents that hope to make a profit by accepting exchange rate risk. Speculators engage in the forward exchange market because they believe that the future spot rate corresponding to the date of the quoted forward exchange rate will be different to the quoted forward rate.

Example on page 27

A speculator hopes to make money by taking an open position in the foreign currency

Uncovered Interest Rate Parity

Since international investors can quickly and easily switch out of domestic bonds into foreign bonds and vice versa, the exchange rate can be viewed as a relative asset price.

where is the expected rate of depreciation of the exchange rate of the pound, defined as pounds per dollar.

is the UK interest rate and is the US interest rate.

Equation (7.1) is known as the uncovered interest parity condition (UIP). UIP states that the expected rate of depreciation of the pound against the dollar is equal to the interest rate differential between UK and US bonds.

Example: if the interest rate in the UK is 10% per annum while the interest rate in the US is 4% per annum, then on average, international investors expect the pound to depreciate by 6% per annum.

Further example on page 150

The UIP condition implies that the expected rate of return on domestic and foreign bonds are equal. For the UIP condition to hold continuously, it requires that capital is perfectly mobile so that investors can instantly alter the composition of their international investments. For the UIP condition to hold, investors must also regard UK and US bonds as equal risky. If this was not the case, then investors that are risk-averse would require a higher expected return on the riskier asset causing the UIP condition to no longer hold.

When there is both perfect capital mobility and equal riskiness of domestic and foreign bonds, UK and US bonds are said to be perfect substitutes. Perfect substitutability of domestic and foreign bonds implies that the UIP condition will hold on a continuous basis.

Box 7.1 on page 151.