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)
• 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:
• Appendix 1: PPP within the Monetary Approach to the B of P
PPP: ALTERNATIVE DEFINTIONS
Absolute PPP :
P ≡ price of a basket of goods in domestic currency
esp. from the World Bank’s International Comparison Program.
• RER = 1,
•
P = E P*
•
𝑃
E=
𝑃∗
𝑃∗
where real exchange rate RER ≡ E
𝑃
=
1/𝑃∗
1/𝑃
ITF-220 Prof.J.Frankel
PPP: ALTERNATIVE DEFINTIONS (continued)
Relative PPP
CPI ≡ is a price index, expressed relative to an arbitrary base year
e.g., “CPI2000 ≡ 100.0” (from national agencies).
Define real exchange rate Q ≡ E 𝐶𝑃𝐼∗
.
𝐶𝑃𝐼
• Q is constant (at 𝑄),
• CPI =
1
𝑄
or
E=
𝐶𝑃𝐼
𝑄
.
𝐶𝑃𝐼∗
(E)(CPI*) .
• Depreciation = π - π*, where π and π* are
domestic & foreign inflation rates.
Prof. Jeffrey Frankel, Harvard Kennedy School
Does PPP hold in practice?
• No.
• Q varies a lot.
ITF-220 Prof.J.Frankel
Four patterns of
deviation from PPP
and their likely origins:
Q
Q
a) Band <= barriers
b) Random walk
<= shifts in
terms of trade
c) Trend <= BalassaSamuelson effect
d) Autoregression
<= sticky prices .
Band
Random Walk
Q
Q
𝑄
Trend
ITF-220 Prof.J.Frankel
Autoregression
Barriers to International Integration
of Goods Markets
• Transportation costs, which depend on:
• geography
• technology
• Tariffs & non-tariff trade barriers
• Currencies
• Other border frictions
ITF-220 Prof.J.Frankel
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)
ITF-220 Prof.J.Frankel
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
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.
ITF-220 Prof.J.Frankel
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? ”
ITF-220 Prof.J.Frankel
Business Review, Fed,Res,Bank of Philadelphia,
Q2. Table 2.
High trade
barriers in
agricultural
products
are still
common,
preventing
price
arbitrage.
ITF-220 Prof.J.Frankel
Prices of nontraded
services vary widely.
Notice that they are
lower in poorer (lowwage) countries
than rich.
ITF-220 Prof.J.Frankel
Jan.22, 2014
Why is the price
of Big Macs
so high in Norway?
Big Macs are
partly traded
(ingredients) &
partly nontraded
(cooking & retail).
Their price varies
widely across
countries.
higher in Brazil
than in Japan?
Low in India
& S.Africa?
ITF-220 Prof.J.Frankel
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
either way,
E ↓ (under a float)
=> (E P*/CPI)↓ :
or PNTG ↑ => CPI ↑
real appreciation.
{
}
ITF-220 Prof.J.Frankel
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
Sticky goods prices =>
autoregressive pattern in real exchange rate
(though you need 100 years of data to see it)
WWI inflation
1925 ₤
return
to gold
Thatcher
1931, 49, 69 appreciation 1990: ₤
₤ devaluations
entered
EMS
UK inflation during
Bretton Woods era
ITF-220 Prof.J.Frankel
1992:
₤ left
EMS
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 realize that prices adjust,
• closing about ¼ 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 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 ↑
the “real balance effect.”
• => Res rising over time
• + Nonsterilization
}
M rising over time
=> BP is self-correcting.
ITF-220 Prof.J.Frankel
Appendix 2: Transport Costs since the 19th century
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)
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)
ITF-220 Prof.J.Frankel
Appendix 3:
The Big Mac
Index in 2000.
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
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.
ITF-220 Prof.J.Frankel
1/Q
Balassa-Samuelson
relationship
Source: “The Purchasing Power Parity Puzzle,” by Kenneth Rogoff, Journal of Economic Literature (1996).
ITF-220 Prof.J.Frankel