LECTURE 10: Purchasing Power Parity Primary Motivation: How realistic is the assumption P = ? Secondary motivation: How integrated are global goods markets?

LECTURE 10: Purchasing Power Parity

• Primary Motivation: How realistic is the assumption P = ?• Secondary motivation: How integrated are global goods markets?

• Definition(s) of PPP (Absolute vs. Relative PPP)

• PPP within the Monetary Approach to the B of P• Does PPP hold in practice?

• Barriers to international goods market arbitrage• Four observed patterns of deviation from PPP• Arbitrage enforces the Law Of One Price in some sectors, but not in others:

P

ITF-220 Prof.J.Frankel

PPP: ALTERNATIVE DEFINTIONS

Absolute PPP : P ≡ price of a basket of goods in domestic currency.

•

•

• RER =1, where real exchange rate RER

• In logs: e = p - p*.

*EPP

*P

PE

P

EP*

P

P

/1

*/1

Prof. Jeffrey Frankel, Harvard Kennedy School

PPP: ALTERNATIVE DEFINTIONS (continued)

Relative PPP CPI ≡ is a price index, expressed relative to an arbitrary base year

e.g., “CPI2000 ≡ 100.0” (from national agencies).

• or .

• Q is constant (at ), where real exchange rate Q ≡

• In logs, Δe = Δ cpi – Δ cpi* (relative to some base year).

• Annual depreciation = π - π* .

*))((1

CPIEQ

CPI *CPI

CPIQE

QCPI

CPIE

*


PPP within the MABP:Effect of a devaluation

• E ↑ => P ↑ => (M/P) ↓ => • (M/P)<L => “Excess Demand for Money” =>

• residents cut back spending on goods (or assets)

• => BP ↑ the “real balance effect”

• => Res rising over time

• + Nonsterilization M rising over time

=> BP is self-correcting.

}


Does PPP hold in practice?

• No.

• Q varies a lot.

Four patterns ofdeviation from PPP

and their likely origins:

a) Band <= barriers

b) Random walk <= shifts in terms of trade

c) Trend <= Balassa-Samuelson effect

d) Autoregression <= sticky prices .

Band Random Walk

Trend Autoregression

Q

Q Q

Q Q



BARRIERS TO INTERNATIONAL INTEGRATION OF GOODS MARKETS

• Transportation costs, which depend on:

• geography

• technology

• Tariffs & non-tariff trade barriers

• Currencies

• Other border frictions

Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING 1869-1950 by Saif I. Shah Mohammed and Jeffrey G. WilliamsonNBER Working Paper 9531 (http://www.nber.org/papers/w9531)

Long distance transport costs fell during the 19th century.


By 1914, low transport costs, UK-led free trade, & the Pax Brittanica allowed arbitrage between the US & UK in wheat.



Arbitrage enforces the Law Of One Price in some sectors, but not in others

• For homogeneous mineral & agriculturalcommodities, the Law of One Price– holds, if there are no trade barriers (gold),– fails, if there are trade barriers (sugar).

• For goods & services not traded internationally, there can be no arbitrage (haircuts).

• Other sectors fall in between :– Manufactured goods.– Big Mac hamburgers.

The Law of One Price holds relatively wellfor a standardized metal such as gold.

G.Alessandria & J.Kaboski, 2008, “Why are Goods So Cheap in Some Countries? ” Business Review, Fed,Res,Bank of Philadelphia, Q2. Table 2.

Note: India has tariffs & quotas on gold imports.{


https://sites.google.com/site/georgealessandria2/BR-AK.pdf?attredirects=0



High trade barriers in

agricultural products are still

common, preventing

price arbitrage.


Prices of nontraded services vary widely.Notice that they are

lower in poorer (low-wage) countries

than rich.


Big Macs are partly traded (ingredients) & partly nontraded (cooking & retail).Their price varies widely across countries.

Jan.22, 2014

Why is the price of Big Macs

so high in Norway & Switzerland?

than in Japan?

higher in Brazil

Low in India & S.Africa?


Non-Traded Goods• Even if arbitrage quickly equalized prices for traded goods,

it would not do so for goods that are not traded internationally.

• If the price of Non-Traded Goods rises more rapidly in Japan than in the US, then the yen will come to appear overvalued in real terms, i.e., relative to PPP.

• Balassa-Samuelson effect: higher income per capita => higher relative price of non-traded goods => real appreciation.– Usual mechanism: the higher productivity occurs in Traded Goods sector

= > ( PTG /PNTG ) ↓ .

– But PTG = E PTG *, tied to world markets =>

PNTG ↑ => CPI ↑ => (E P*/CPI)↓ ,

Or E ↓ real appreciation.

{ }

Balassa-Samuelson relationship: Absolute price levels are higher in rich countries

(real exchange rates are lower).

G.Alessandria & J. Kaboski, 2008, “Why are Goods So Cheap in Some Countries? ” Bus.Rev, Fed.Res. Bank of Philadelphia, Q2. Fig.1

1/Q




Sticky goods prices => autoregressive pattern in real exchange rate

(though you need 200 years of data to see it)

1925 ₤ return to gold

1931, 49, 69₤ devaluations

UK inflation duringBretton Woods era

Thatcherappreciation

1990: ₤ enteredEMS

1992: ₤ leftEMS

Bottom line conclusion from PPPfor the rest of the course

• For most goods & services, prices are “sticky”– i.e., we can take their prices as exogenous in the SR.– Exceptions:

• mostly agricultural & mineral products• Especially in very small open economies.

• After a few years pass (Medium Run), we must take into account that prices adjust,

• closing about ¼ gap per year.

• In the Long Run, prices may adjust fully,– returning us to a LR PPP equilibrium,– although even in the LR there can be changes in ,

• E.g. from exogenous changes in terms of trade• Or from Balassa-Samuelson effect.

Q

Q


Long distance transport costs fell sharply during the 19th century.


Appendix 1: Transport Costs since the 19th century




Appendix 2:The Big Mac Index in 2000.

The price tends to be higher in rich countries (e.g., Europe & Japan, compared to China),

and in countrieswith overvalued currencies (e.g., Argentinain 2000).


Source: The Economist, January 2003.

Three years later,Big Macs were still expensive in Europe and cheap in China;

but now (2003), they were cheaper still in Argentina.

Why?

Devaluation.

Source: “The Purchasing Power Parity Puzzle,” by Kenneth Rogoff, Journal of Economic Literature (1996).

Balassa-Samuelsonrelationship

1/Q


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LECTURE 10: Purchasing Power Parity Primary Motivation: How realistic is the assumption P = ? Secondary motivation: How integrated are global goods markets?