LECTURE 10: Purchasing Power Parity - Harvard University · LECTURE 10: Purchasing Power Parity • Primary Motivation: How realistic is the assumption P = ? ... Long-distance transport

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

ITF-220 Prof.J.Frankel

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, where real exchange rate RER ≡ E 𝑃∗

𝑃

• P = E P*

• E = 𝑃

𝑃∗

= 1/𝑃∗

1/𝑃

Prof. Jeffrey Frankel, Harvard Kennedy School

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 (E)(CPI*) .

• Depreciation = π - π*, where π and π* are

domestic & foreign inflation rates.

or E = 𝑄 𝐶𝑃𝐼

𝐶𝑃𝐼∗.

ITF-220 Prof.J.Frankel

Does PPP hold in practice?

• No.

• Q varies a lot.

Four patterns of deviation from PPP and their likely origins:

a) Band <= barriers

b) Random walk <= shifts in terms of trade

c) Trend <= Balassa-Samuelson effect

d) Autoregression <= sticky prices .

Band Random Walk

Trend Autoregression

Q Q

Q Q

ITF-220 Prof.J.Frankel

𝑄

ITF-220 Prof.J.Frankel

Barriers to International Integration of Goods Markets

• Transportation costs, which depend on:

• geography

• technology

• Tariffs & non-tariff trade barriers

• Currencies

• Other border frictions

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)

Long-distance transport costs fell during the 19th century.

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

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.

The Law of One Price holds relatively well for a standardized metal such as gold.

G.Alessandria & J.Kaboski, 2008, “Why are Goods So Cheap in Some Countries? ” Business Review, Fed,Res,Bank of Philadelphia, Q2. Table 2.

Note: India has tariffs & quotas on gold imports. {

ITF-220 Prof.J.Frankel

ITF-220 Prof.J.Frankel

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 (low-

wage) countries

than rich.

ITF-220 Prof.J.Frankel

Big Macs are partly traded (ingredients) & partly nontraded (cooking & retail). Their price varies widely across countries.

Jan.22, 2014

Why is the price of Big Macs

so high in Norway?

than in Japan?

higher in Brazil

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

{ } or PNTG ↑ => CPI ↑

either way, => (E P*/CPI)↓ : real appreciation.

E ↓ (under a float)

Balassa-Samuelson relationship: Absolute price levels are higher in rich countries

(real exchange rates are lower).

G.Alessandria & J. Kaboski, 2008, Bus.Rev, Fed.Res. Bank of Philadelphia, Q2. Fig.1

1/Q

ITF-220 Prof.J.Frankel

Sticky goods prices => autoregressive pattern in real exchange rate

(though you need 100 years of data to see it)

1925 ₤ return to gold

1931, 49, 69 ₤ devaluations

UK inflation during Bretton Woods era

Thatcher appreciation 1990: ₤

entered EMS

1992: ₤ left EMS

WWI inflation

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.

ITF-220 Prof.J.Frankel

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.

}

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)

Appendix 2: Transport Costs since the 19th century

ITF-220 Prof.J.Frankel

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

Source: The Economist, January 2003.

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 Purchasing Power Parity Puzzle,” by Kenneth Rogoff, Journal of Economic Literature (1996).

Balassa-Samuelson relationship

1/Q

ITF-220 Prof.J.Frankel