Lecture 5: Balassa-Samuelson Hypothesis
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1 Lecture 5: Balassa-Samuelson Hypothesis Xu Hu School of Economics Fudan University September 29, 2013
2 Law of One Price Spatial Arbitrage: a highly trade-able and homogeneous good should have equal prices in different places.
3 Law of One Price Spatial Arbitrage: a highly trade-able and homogeneous good should have equal prices in different places. Big Mac:
4 Law of One Price Spatial Arbitrage: a highly trade-able and homogeneous good should have equal prices in different places. Big Mac: Starbucks Grande Latte: Region Local Currency Price Dollar Price % deviation-us US Britain % Canada % Japan % China % source:
5 Law of One Price Balassa 1964 J.P.E.: the purchasing power parity doctrine...a ratio of consumer goods prices for any pair of countries would tend to approximate the equilibrium rates of exchange. RMB cost of a basket of goods = RMB per US dollar (1) US dollar cost of a basket of goods
6 Law of One Price Balassa 1964 J.P.E.: the purchasing power parity doctrine...a ratio of consumer goods prices for any pair of countries would tend to approximate the equilibrium rates of exchange. RMB cost of a basket of goods = RMB per US dollar (1) US dollar cost of a basket of goods transaction costs & trade impediments such tariffs and quotas
7 Law of One Price Balassa 1964 J.P.E.: the purchasing power parity doctrine...a ratio of consumer goods prices for any pair of countries would tend to approximate the equilibrium rates of exchange. RMB cost of a basket of goods = RMB per US dollar (1) US dollar cost of a basket of goods transaction costs & trade impediments such tariffs and quotas market structure: monopoly price discrimination
8 Law of One Price Balassa 1964 J.P.E.: the purchasing power parity doctrine...a ratio of consumer goods prices for any pair of countries would tend to approximate the equilibrium rates of exchange. RMB cost of a basket of goods = RMB per US dollar (1) US dollar cost of a basket of goods transaction costs & trade impediments such tariffs and quotas market structure: monopoly price discrimination non-traded goods
9 PPP What determines P/S in the long run? (2) P P national price level; P foreign price level; S national currency per foreign currency
10 Balassa-Samuelson goods: labor unit cost in US: labor unit cost in China: good 1 is non-traded while good 2 & 3 are the tradables
11 Balassa-Samuelson goods: labor unit cost in US: labor unit cost in China: good 1 is non-traded while good 2 & 3 are the tradables labor is mobile between different sectors
12 Balassa-Samuelson goods: labor unit cost in US: labor unit cost in China: good 1 is non-traded while good 2 & 3 are the tradables labor is mobile between different sectors P j denotes the nominal price of good j in China; P j denotes the nominal price of good j in US.
13 Balassa-Samuelson goods: labor unit cost in US: labor unit cost in China: good 1 is non-traded while good 2 & 3 are the tradables labor is mobile between different sectors P j denotes the nominal price of good j in China; P j denotes the nominal price of good j in US. good 1 is relatively cheaper in China than in US?
14 Balassa-Samuelson Purchasing Power Parity? P 1 q 1 + P 2 q 2 + P 3 q 3 P 1 q 1 + P 2 q 2 + P 3 q 3 = S? (3)
15 Balassa-Samuelson Purchasing Power Parity? Look at P 1 q 1 + P 2 q 2 + P 3 q 3 P 1 q 1 + P 2 q 2 + P 3 q 3 P 1 S q 1 + P 2 S q 2 + P 3 S q 3 P 1 q 1 + P 2 q 2 + P 3 q 3 = S? (3) < 1 (4)
16 Balassa-Samuelson Conclusion: in the long run rich countries have higher costs of living, due to higher prices of non-traded goods.
17 Balassa-Samuelson Conclusion: in the long run rich countries have higher costs of living, due to higher prices of non-traded goods. Assumptions: rich countries are relatively more productive in tradeable sector factor mobile across sectors within a country
18 Balassa-Samuelson Conclusion: in the long run rich countries have higher costs of living, due to higher prices of non-traded goods. Assumptions: rich countries are relatively more productive in tradeable sector factor mobile across sectors within a country Two interpretations: cross section & time series
19 appears unsatisfactory, it is a different ers, who have suggested that comparisons be made with some previous period purchasing power of national currencies taken as a norm. can provide an indication of the required This formulation of the purchasing- Balassa-Samuelson: question whether changes in the empirical relative evidences US cc (D CANADA j 90 SWEDEN x X 3 u U.K. X 80 NORWAY x XBEGU 80 :LD ji/germany z XDENMARK < 0 W 70 ITALY x FRANCE w / NETHERLANDS LLI 60 / JAPAN 50 Y X (.003) PER CAPITA G.N.R FIG. 1 TABLE 4 PURCHASING-POWER PARITIES FOR GROSS
20 tion and entertainment Belgium and power parities, exchange rates, and per capita income levels. And whereas the I have suggested above that the higher application of the purchasing-power parlevel of service prices at higher income ity doctrine is seen to give incorrect anlevels leads to systematic differences be- swers for determining equilibrium ex- Balassa-Samuelson: Norway (Table 3). empirical evidences TABLE 3 PURCHASING-POWER EQUIVALENTS FOR SERVICES AS A PERCENTAGE OF EXCHANGE RATES, 1950* Belgium Denmark France Germany Italy Netde Norway Kingdom landskigo GNP per capita ($) Purchasing power equivalants: Household and personal services Public transport services Recreation and entertainment Health... Education Government administra- Services, total tive personnel... Defense personnel (20.0) Grossnationalproduct * The original data are expressed in terms of national currencies per U.S. dollar. All calculations have been made at U.S. and given-country weights, and a geometrical average of the results has been taken. Source: Milton Gilbert and Associates, Comparative National Products and Price Levels (Paris: OEEC. 1960). pd tween purchasing-power parities and change rates, the observed relationship
21 Renminbi Undervalued? Use cross section data to estimate Balassa-Samuelson relationship: regress real exchange rate against real income per capita Evaluate Renminbi by Balassa-Samuelson relationship.
22 Renminbi Revaluate? Not in a dilemma; Lecture 1-2
23 Renminbi Revaluate? Not in a dilemma; Lecture 1-2 Slow economic growth? Lecture 3
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