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 isE $/¥ = P US i / P J i for all i, where P US i = price of good i in US P J i = price of good i in Japan

Purchasing Power Parity (PPP) Absolute PPP The equivalence of the exchange rate to the ratio of the foreign and domestic price levels That isE $/¥ = P US / P J where P US = price level of US P J = 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 $/¥ = ^P US - ^P J 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.

CityMans HaircutWomans Cut And Blow Dry Countrys per Capita Income 1988 Zurich ,500 Tokyo ,020 New York City ,840 Frankfurt ,480 Paris ,090 London ,810 Sydney ,340 Hong Kong ,220 Sao Paulo ,160 Mexico City ,760 Moscow NA

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.