– Transportation costs
– Tariffs & non-tariff trade barriers
– Border frictions
– Currencies.
– The relative price of NTGs
– The Balassa-Samuelson Effect
– Deviations from the Balassa-Samuelson line.

Long distance transport costs fell sharply during the late 19th century.
Real Freight Rates for Jute from Calcutta to UK (1884=1.00)
Saif I. Shah Mohammed & Jeffrey G. Williamson, 2004,
"Freight rates and productivity gains in British tramp shipping 1869–1950." Explorations in Economic History 41.2: 172-203.
API-120 - Prof. J. Frankel

By 1914, low transport costs,
UK-led free trade,
& the Pax
Brittanica allowed arbitrage between the US & UK in wheat.

Agricultural products still feature high trade barriers, preventing price arbitrage.
API-120 - Prof. J. Frankel

CROSS-BORDER TRADE BARRIERS: KEY FINDINGS
(after controlling for trade policy & geographic variables)
Gravity model of volume of
trade shows:
Even across the Canadian-
U.S. border, firms trade with fellow citizens 20 x as much as cross-border
(5 x, after controlling for FTA, etc.) --
McCallum
(1995);
Helliwell
(1998)
.
Looking at trade among a large sample
of countries, a difference in currencies, in particular, cuts trade by 3
-Rose
(2000).
Evidence of arbitrage in price differentials shows: frictions in crossing the border >> frictions in going from one end of country to the other
-Engel & Rogers
(1996) .
different currencies, in particular, explain some of the border frictions
-- Parsley & Wei
(2001)
; Cavallo,
Neiman & Rigobon
(2014).
API-120 - Prof. J. Frankel

Engel & Rogers “How Wide is the Border?” AER
(1996)
Crossing the border, e.g., from Vancouver to Seattle, adds more friction into price arbitrage than traveling the length of the continent from Atlantic to Pacific.
API-120 - Prof. J. Frankel

Andrew Rose, 2000, “One Money, One Market? The Effect of Currencies on International Trade,” Economic Policy.
The gravity model of bilateraltrade shows that such barriers as distance, tariffs, borders, etc., still matter.
• Rose (2000): A reduction in bilateral exchange rate variability encourages trade.
• More surprisingly, joining a currency union results in an estimated tripling of trade among the partners,
• even after controlling for colonial history, etc.,
(exp(1.2)=3).

Why is the cost of living so high in
Tokyo and so low in Mumbai?
Why was Buenos
Aires in 2001 more expensive than Paris or
Frankfurt ?...
API-120 - Prof. J. Frankel

In 2004, Tokyo was still very expensive.
But Buenos Aires had fallen far below Paris or Frankfurt.
Why?
The peso collapsed in 2002.
API-120 - Prof. J. Frankel

The real exchange rate varies with each country’s relative price of NTGs.
Q ≡
(𝐸)(𝐶𝑃𝐼∗)
(𝐶𝑃𝐼)
≡
𝐸 (𝑃
(𝑃
𝑇𝐺
𝑇𝐺
∗
1−α
1−α
𝑃
𝑃
𝑁𝑇𝐺
𝑁𝑇𝐺
α )
∗
α
) where α ≡ weight of NTGs in price basket.
≡
𝐸𝑃
𝑇𝐺
(𝑃
𝑇𝐺
∗ (𝑃
) (𝑃
𝑇𝐺
∗
−α
𝑇𝐺
−α
𝑃
𝑁𝑇𝐺
𝑃
𝑁𝑇𝐺
α
∗
α
)
) assuming arbitrage works for TGs.
Q =
(𝑃
𝑁𝑇𝐺
(𝑃
𝑁𝑇𝐺
∗/𝑃
𝑇𝐺
∗)
/𝑃𝑇𝐺) α
α
API-120 - Prof. J. Frankel

One important application of TG/NTGs, esp. for long-run trends.
(P
NTG
/P
TG
)
-and therefore 1/ Q -- rises with countries’ real incomes.
The usual B-S reason: Productivity growth takes place in the TG sector, reducing prices there relative to wages and P
NTG.
The statistical relationship between income per capita and the absolute real exchange rate is well documented .
Some cross-section studies:
• the original Balassa article (1964)
•
• Rogoff (1996):
• recent studies of RMB undervaluation (see appendix 2).
= .04 + .37
(.09) (.04)
It takes more work to verify that productivity growth operates via the relative price of NonTraded Goods.
• E.g., DeGregorio, Giovannini & Wolf (1994).
API-120 - Prof. J. Frankel

The original
Belassa article showed
1960 levels.
API-120 - Prof. J. Frankel

Distinguishng TGs from NTGs is difficult in practice.
Estimates of tradability calculated for about 200 products, as the worldwide trade/output ratio, relative to average tradability of all products
If more than 2% of the sector is traded, it must be tradable .
Tradable goods
Non-
Tradable
Goods
Data: 20 OECD countries, 1985-1999, from UNIDO (2000) & US.Commerce Dept. (2002).
Source: Robert E. Lipsey & Birgitta Swedenborg, 2010, Review of World Economics . http://www.nber.org/papers/w13239

De Gregorio,
Giovannini &
Wolf
(1994),
“International Evidence on Tradables and
Nontradables Inflation”
In almost all countries, the ratio of NTG prices to TG prices rises over time (“Baumol’s cost disease”).
Japan had the strongest trend during the post-war period .
API-120 - Prof. J. Frankel

The countries with the strongest productivity growth tend to show the strongest upward trend in the relative prices of NTGs
(1970-1985) .
API-120 - Prof. J. Frankel

1/Q
Absolute price levels are higher in rich countries
(real exchange rates are lower).
G.Alessandria & J. Kaboski, 2008, “Why are Goods So Cheap in Some Countries? ” Bus.Rev, Fed.Res. Bank of Philadelphia, Q2. Fig.1

re-estimated
• Every 1% increase in real income/capita is associated on average with .38% real appreciation.
• In any given year, many countries lie far off the line.
• E.g., China’s RMB appeared “undervalued,” even relative to the B-S relationship,
– by 25% in 2009.
• What causes currencies to deviate from the B-S line?
– Devaluation/revaluation, or
– Fixed nominal exchange rate plus inflation or rapid productivity growth.
– But gaps from the B-S line tend to correct 1/2-way per decade.
API-120 - Prof. J. Frankel

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

Jose Campa & Linda Goldberg
(2005)
• Passthrough of exchange rate changes to import prices is low into the US market (especially in the SR).
• But for most other countries, the passthrough coefficient is above 50% even in the SR, and not statistically different from 1 in the LR.
• In most, the coefficient fell during the 1990s.
• Compositional differences of price indices
(e.g., more weight on oil vs. autos) can alone explain part of the variation in passthrough coefficients.
• The passthrough coefficient depends on inflation & exchange rate volatility .
API-120 - Prof. J. Frankel

Jose Campa &
Linda Goldberg,
2005,
“Exchange Rate Pass
Through into Import Prices,"
Review of Econ. & Stats.
API-120 - Prof. J. Frankel

Cross-section of 118 countries
Fitted values
CHN
logRER00
.370385
Log of real exchange value of country’s currency (1/Q)
CHN
-2.15096
6.17768
loginc00
10.6917
Log of real income
3 paths to an “undervalued” currency: (i) devaluation, (ii) low inflation,
(iii) fixed exchange rate during a long period of rapid productivity growth .
Frankel (2006): “On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,” Understanding the Chinese Economy, G.Illing, ed. (OUP).

2005
-3 -2 -1 0
Log of Real Per capita GDP (PPP)
1 coef = .23367193, (robust) se = .01978263, t = 11.81
2
Source: Arvind Subramanian
(2010), PB10-08, Peterson Institute for International Economics.
Undervaluation of the 2005 RMB in the estimated regression = 26%.
Compare to estimate for 2000
(Frankel 2005):
36%.
As recently as 2009
(Chang 2012) :
25% .
22

In 2014, the ICP released new absolute price data.
“Is the Renminbi Still Undervalued? Not According to New PPP Estimates” by M.Kessler & A.Subramanian, PIIE, May 2014
Benchmark years
2005
2011
GDP per capita (in PPP dollars) RMB undervaluation (percent)
4,802
10,057
-34.5
-9.7
API-120 - Prof. J. Frankel

overvaluation/undervaluation for 2009.
Balassa-Samuelson line
Source: Gene Chang
“Theory and Refinement of the Enhanced-PPP
Model for Equilibrium Exchange Rates,” 2011.
China: 25% undervaluation
The RMB continued to appreciate in real terms.
It has approximately completed its adjustment, as also shows up in the trade balance.
http://www.jeffrey-frankel.com/2012/03/26/china-adjusts/
API-120 - Prof. J. Frankel