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) 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:

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

PPP: ALTERNATIVE DEFINTIONS

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

P EP*
P E P*
1/ P * 1/ P

EP * Q=1, where real exchange rate Q P

In logs: e = p - p*.
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Copyright 2007 Jeffrey Frankel, unless otherwise noted

PPP: ALTERNATIVE DEFINTIONS (continued)

Relative PPP:
P price index of a basket of goods in domestic currency
expressed relative to an arbitrary base year (e.g., P2000 100.0).

1 P EP * Q

or

P E Q P*

Q is constant. In logs, e = p p* (relative to some base year). Annual depreciation = - * .

Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

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.

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Does PPP hold in practice?

No.

Q varies a lot.

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Four patterns of deviation from PPP

and their likely origins:
a) Band <= barriers

b) Random walk <= shifts in terms of trade c) Trend <= BalassaSamuelson effect
d) Autoregression <= sticky prices .
Q

Band

Random Walk

Trend

Autoregression

BARRIERS TO INTERNATIONAL INTEGRATION OF GOODS MARKETS

Transportation costs, which depend on:
geography technology Tariffs & non-tariff trade barriers

Currencies
Other border frictions
Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Long distance transport costs fell 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)

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 & 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.
Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Source: The Purchasing Power Parity Puzzle, by Kenneth Rogoff, Journal of Economic Literature, Vol. 34, No. 2. (Jun., 1996), pp. 647-668.

High trade barriers in agricultural products are still common, preventing price arbitrage.
Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Prices of nontraded services vary widely. Notice that they are lower in poorer (lowwage) countries than rich.

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

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

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).
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

Copyright 2007 Jeffrey Frankel, unless otherwise noted

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 Economist, January 2003.

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

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 Or E

=> (E P*/CPI) ,

real appreciation.

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

1/Q

Balassa-Samuelson relationship

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

Sticky goods prices => autoregressive pattern in real exchange rate

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

1925 return to gold

Thatcher 1931, 49, 69 appreciation 1990: entered devaluations EMS

UK inflation during Bretton Woods era

1992: left EMS

Copyright 2007 Jeffrey Frankel, unless otherwise noted

API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

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 take into account that prices adjust,
closing about 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.

Appendix
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)
Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

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)
Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University