Prices and Exchange Rates
Purchasing Power Parity
Purchasing Power Parity

Similar goods tend to sell for similar prices worldwide.

Law of One Price
All goods must sell for the same price worldwide when converted
into a common currency (if there is no transportation costs and no
trade barriers).
That is
E$/¥ = PUSi / PJi
where
PUSi = price of good i in US
PJi = price of good i in Japan
for all i,
Purchasing Power Parity (PPP)

Absolute PPP
The equivalence of the exchange rate to the ratio of the
foreign and domestic price levels
That is
where
E$/¥ = PUS / PJ
PUS = price level of US
PJ = price level of Japan
price level = price of a reference commodity basket
Purchasing Power Parity (PPP)

Relative PPP
The equivalence of the percentage change in the
exchange rate to the inflation differential (the difference
of the foreign and domestic changes in price levels).
That is
^E$/¥ = ^PUS - ^PJ
or
^E$/¥ = US - J
where
^() = % change in ()
US = inflation rate in US
J = inflation rate in Japan
Purchasing Power Parity (PPP)

The law of one price implies but is not implied by PPP.

Absolute PPP implies but is not implied by Relative PPP.
“Overvalued” and “Undervalued” Currencies



“Overvalued” currency: Currency worth more than
PPP value
“Undervalued” currency: Currency worth less than
PPP value
In the early 1980s, may people said that dollar was
overvalued.
Inflation and relative price changes





Relative price changes  real shocks
Inflation  nominal shocks
Relative price movements are short run phenomena and
tend to cancel out over time.
In the long run, inflation dominates exchange rate
movements.
PPP holds better in the long run than in the short run.
Inflation and relative price changes

PPP holds better for high-inflation countries.

Even if law of one price holds perfectly for individual
goods, PPP could be violated for a price index.

Data does not give much empirical support to PPP.
Factors explaining the poor performance of
PPP
Trade restrictions and transport costs


For some goods, transport costs are so large that they can never be
traded internationally.  Nontraded goods (nontradables)

Examples: construction (e.g. homebuilding), services (e.g. haircut),
and domestic transportation (e.g. bus and train services).

Exception: South Korean construction firms in Middle East in 70s and
80s.

Local demand and supply determine their prices.

50% of US GNP is nontradables.
Factors explaining the poor performance of
PPP

Imperfectly competitive markets
Price discrimination: sells a commodity at different prices in
different countries.

Differences in price level measures
Different baskets in different countries.
Man’s Haircut
Woman’s Cut
And Blow Dry
Zurich
34.47
36.83
27,500
Tokyo
27.78
46.40
21,020
New York City
21.66
27.00
19,840
Frankfurt
13.64
20.20
18,480
Paris
23.87
36.81
16,090
London
17.32
28.60
12,810
Sydney
18.05
25.99
12,340
Hong Kong
14.06
18.75
9,220
Sao Paulo
7.33
15.95
2,160
Mexico City
6.50
9.94
1,760
Moscow
6.78
9.57
NA
City
Country’s per
Capita Income 1988
Why haircuts prices are lower in poorer
countries?

Assume:

Productivity in the tradables sector is higher in
developed countries than in developing countries.

Productivity in the nontradables sector is similar in both
groups.

Prices of tradables are the same in both groups.
Why haircuts prices are lower in poorer
countries?






Then: in developing countries
 lower productivity in tradables
 lower wage relative to developed countries
 lower costs for nontradables
 lower prices of nontradables
Relative prices of nontradables will increase as real per
capita income increases.