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LECTURE 10: Purchasing Power Parity
• Primary Motivation: How realistic is the assumption P = 𝑃 ? • Secondary motivation: How integrated are global goods markets?
• Definition(s) of PPP (Absolute vs. Relative PPP)
• 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:
• Appendix 1: PPP within the Monetary Approach to the B of P
ITF-220 Prof.J.Frankel
PPP: ALTERNATIVE DEFINTIONS
Absolute PPP : P ≡ price of a basket of goods in domestic currency esp. from the World Bank’s International Comparison Program.
• RER = 1, where real exchange rate RER ≡ E 𝑃∗
𝑃
• P = E P*
• E = 𝑃
𝑃∗
= 1/𝑃∗
1/𝑃
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).
Define real exchange rate Q ≡ E 𝐶𝑃𝐼∗
𝐶𝑃𝐼 .
• Q is constant (at 𝑄 ),
• CPI = 1
𝑄 (E)(CPI*) .
• Depreciation = π - π*, where π and π* are
domestic & foreign inflation rates.
or E = 𝑄 𝐶𝑃𝐼
𝐶𝑃𝐼∗.
Four patterns of deviation 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
ITF-220 Prof.J.Frankel
𝑄
ITF-220 Prof.J.Frankel
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. Williamson NBER Working Paper 9531 (http://www.nber.org/papers/w9531)
Long-distance transport costs fell during the 19th century.
ITF-220 Prof.J.Frankel
By 1914, low transport costs, UK-led free trade, & the Pax Brittanica allowed arbitrage between the US & UK in wheat.
ITF-220 Prof.J.Frankel
ITF-220 Prof.J.Frankel
Arbitrage enforces the Law Of One Price in some sectors, but not in others
• For homogeneous mineral & agricultural commodities, 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 well for 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. {
ITF-220 Prof.J.Frankel
ITF-220 Prof.J.Frankel
High trade barriers in
agricultural products
are still common,
preventing price
arbitrage.
ITF-220 Prof.J.Frankel
Prices of nontraded
services vary widely.
Notice that they are
lower in poorer (low-
wage) countries
than rich.
ITF-220 Prof.J.Frankel
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?
than in Japan?
higher in Brazil
Low in India & S.Africa?
ITF-220 Prof.J.Frankel
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
{ } or PNTG ↑ => CPI ↑
either way, => (E P*/CPI)↓ : real appreciation.
E ↓ (under a float)
Balassa-Samuelson relationship: Absolute price levels are higher in rich countries
(real exchange rates are lower).
G.Alessandria & J. Kaboski, 2008, Bus.Rev, Fed.Res. Bank of Philadelphia, Q2. Fig.1
1/Q
ITF-220 Prof.J.Frankel
Sticky goods prices => autoregressive pattern in real exchange rate
(though you need 100 years of data to see it)
1925 ₤ return to gold
1931, 49, 69 ₤ devaluations
UK inflation during Bretton Woods era
Thatcher appreciation 1990: ₤
entered EMS
1992: ₤ left EMS
WWI inflation
Bottom line conclusion from PPP for 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 realize that prices adjust,
• closing about ¼ gap per year.
• In the Long Run, prices may adjust fully, – returning us to a LR PPP equilibrium, 𝑄
– although even in the LR there can be changes in 𝑄 , • e.g., from exogenous changes in terms of trade
• or from Balassa-Samuelson effect.
ITF-220 Prof.J.Frankel
Appendix 1: 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.
}
Long distance transport costs fell sharply during
the 19th century.
Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING 1869-1950 by Saif I. Shah Mohammed and Jeffrey G. Williamson NBER Working Paper 9531 (http://www.nber.org/papers/w9531)
Appendix 2: Transport Costs since the 19th century
ITF-220 Prof.J.Frankel
Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING 1869-1950 by
Saif I. Shah Mohammed and Jeffrey G. Williamson
NBER Working Paper 9531 (http://www.nber.org/papers/w9531)
ITF-220 Prof.J.Frankel
Appendix 3: The Big Mac Index in 2000.
The price tends to be higher in rich countries (e.g., Europe & Japan, compared to China),
and in countries with overvalued currencies (e.g., Argentina in 2000).
ITF-220 Prof.J.Frankel
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.
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