LECTURE 10: Purchasing Power Parity

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

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

(2) Does PPP hold in practice?

(3) Barriers to international goods market arbitrage

(4) 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

(5) The Balassa-Samuelson relationship

(1) Alternate Definitions of PPP

Absolute PPP : P ≡ price of a basket of goods in domestic currency (from the Penn World Tables or the International Comparison Program).

• RER = 1, where real exchange rate RER ≡ E 𝑃∗

𝑃

• P = E P*

• E = 𝑃

𝑃∗

• Or, in logs: e = p - p*.

= 1/𝑃∗

1/𝑃

Then PPP can be defined as:

Prof. Jeffrey Frankel, Harvard Kennedy School

Relative PPP CPI ≡ is a price index, expressed relative to an arbitrary base year e.g., “CPI2000 ≡ 100.0” (from national statistical agencies).

Define real exchange rate Q ≡ E 𝐶𝑃𝐼∗

𝐶𝑃𝐼 .

• Q is constant (at 𝑄 ),

• CPI = 1

𝑄 (E)(CPI*).

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

• Or annual depreciation = π - π* .

E = 𝑄 𝐶𝑃𝐼

𝐶𝑃𝐼∗.

Then PPP can be defined as:

Prof.J.Frankel

(2) Does PPP hold in practice?

• No.

• Q varies a lot.

a) Band <= barriers to trade

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 ≡

Q ≡

- Prof. J.Frankel

•

•

Four patterns of deviation from PPP and their likely origins:

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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

1980: Thatcher appreciation

1990: ₤ entered

EMS

1992: ₤ left EMS

WWI inflation RER

1985: $ peak

Prof.J.Frankel

(3) Barriers to international integration of goods markets

• Transportation costs, which depend on:

• geography

• technology

• Tariffs & non-tariff trade barriers

• Currencies and 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.

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

Prof.J.Frankel

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

• For homogeneous mineral & agricultural commodities,

– holds, if there are no trade barriers (gold),

– fails, if there are trade barriers (sugar).

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

• Other sectors fall in between: – Manufactured goods.

– Big Mac hamburgers.

the Law of One Price

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

High trade barriers in

agricultural products

are still common,

preventing price

arbitrage.

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?

Prof.J.Frankel

(5) The Balassa-Samuelson relationship

• 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

Bottom line conclusions from PPP for the rest of the course

• For most goods & services, prices are “sticky” – i.e., we can take them as exogenous in the Short Run.

– Exceptions: • mostly agricultural & mineral products

• especially in very small open economies.

• After a few years pass prices adjust, – In the Medium Run,

• closing about ¼ gap per year.

• In the Long Run, prices may adjust fully, – returning us to a LR PPP equilibrium, 𝑄 .

– Even in the LR, however, there can be changes in 𝑄 , • e.g., from exogenous changes in terms of trade

• or from Balassa-Samuelson effect.

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 ↑

• => Res rising over time • + Nonsterilization }

the “real balance effect.”

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

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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)

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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).

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 in Argentina.

Why?

Devaluation.