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 M onetary A pproach to the B of P

ITF-220 Prof.J.Frankel

Prof. Jeffrey Frankel, Harvard Kennedy School

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. BandRandom Walk Trend Autoregression Q Q Q 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 by Saif I. Shah Mohammed and Jeffrey G. Williamson NBER Working Paper 9531 ( 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

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. “Why are Goods So Cheap in Some Countries? Note: India has tariffs & quotas on gold imports. { 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 = > ( P TG /P NTG ) ↓. –But P TG = E P TG *, tied to world markets { } or P NTG ↑ => 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

ITF-220 Prof.J.Frankel Appendix 1: PPP within the MABP Effect of a devaluation E ↑ => P ↑ => (M/P) ↓ => (M/P) “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 by Saif I. Shah Mohammed and Jeffrey G. Williamson NBER Working Paper 9531 ( Appendix 2: Transport Costs since the 19 th century

ITF-220 Prof.J.Frankel 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 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 Source: The Economist, January 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