LECTURE 10: Purchasing Power Parity

Transcription

1 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: (5) The Balassa-Samuelson relationship Appendix 1: PPP within the Monetary Approach to the B of P

2 (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 = E P* E = P P Then PPP can be defined as: = 1/P 1/P Or, in logs: e = p - p*. P

3 Relative PPP CPI is a price index, expressed relative to an arbitrary base year e.g., CPI (from national statistical agencies). Define real exchange rate Q E CPI CPI. Then PPP can be defined as: Q is constant (at Q), CPI = 1 Q (E)(CPI*). E = Q CPI CPI. In logs, Δe = Δ cpi Δ cpi* (relative to some base year). Or annual depreciation = π - π*. Prof. Jeffrey Frankel, Harvard Kennedy School

4 (2) Does PPP hold in practice? No. Q varies a lot. Prof.J.Frankel

5 Four patterns of deviation from PPP and their likely origins: Q Q Q a) Band <= barriers to trade b) Random walk <= shifts in terms of trade c) Trend <= Balassa- Samuelson effect d) Autoregression <= sticky prices. Q Band Trend Q Q Random Walk Autoregression - Prof. J.Frankel

6 Sticky goods prices => autoregressive pattern in real exchange rate (though you need 100 years of data to see it) RER WWI inflation 1925 return to gold 1931, 49, 69 devaluations 1980: Thatcher appreciation 1990: entered EMS UK inflation during Bretton Woods era 1992: left EMS 1985: $ peak ITF-220 Prof.J.Frankel

7 (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 Prof.J.Frankel

8 Long-distance transport costs fell during the 19th century. Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING by Saif I. Shah Mohammed and Jeffrey G. Williamson NBER Working Paper 9531 ( Prof.J.Frankel

9 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

10 Prof.J.Frankel (4) 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 is no arbitrage (haircuts). Other sectors fall in between: Manufactured goods. Big Mac hamburgers.

11 The Law of One Price holds relatively well for a standardized metal such as gold. { Note: India has tariffs & quotas on gold imports. G.Alessandria & J.Kaboski, 2008, Why are Goods So Cheap in Some Countries? Business Review, Fed,Res,Bank of Philadelphia, Q2. Table 2.

12 High trade barriers in agricultural products are still common, preventing price arbitrage. ITF-220 Prof.J.Frankel

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

14 Jan.22, 2014 Why is the price of Big Macs Big Macs are partly traded (ingredients) & partly nontraded (cooking & retail). Their price varies widely across countries. so high in Norway? higher in Brazil than in Japan? Low in India & S.Africa? ITF-220 Prof.J.Frankel

15 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 = > ( P TG /P NTG ). But P TG = E P TG *, tied to world markets { E (under a float) either way, } or P NTG => CPI => (E P*/CPI) : real appreciation.

16 Balassa-Samuelson relationship: Absolute price levels are higher in rich countries (real exchange rates are lower). 1/Q G.Alessandria & J. Kaboski, 2008, Bus.Rev, Fed.Res. Bank of Philadelphia, Q2. Fig.1

17 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.

18 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. Prof.J.Frankel

19 Appendix 2: Transport Costs since the 19 th century Long distance transport costs fell sharply during the 19th century. Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING by Saif I. Shah Mohammed and Jeffrey G. Williamson NBER Working Paper 9531 (

20 Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING by Saif I. Shah Mohammed and Jeffrey G. Williamson NBER Working Paper 9531 ( ITF-220 Prof.J.Frankel

21 Appendix 3: The Big Mac Index in 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

22 Three years later, Big Macs were still expensive in Europe and cheap in China; but now (2003), they were cheaper in Argentina. Why? Devaluation. Source: The Economist, January Prof.J.Frankel