LECTURE 10: Purchasing Power Parity Primary Motivation: How realistic is the assumption P = ? Secondary motivation: How integrated are global goods markets? Definition(s) of PPP (Absolute vs. Relative PPP) PPP within the Monetary Approach to the B of P 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:

PPP: ALTERNATIVE DEFINTIONS  Absolute PPP : P ≡ price of a basket of goods in domestic currency. RER =1, where real exchange rate RER In logs: e = p - p*.   ITF-220 Prof.J.Frankel

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). or . Q is constant (at ), where real exchange rate Q ≡ In logs, Δe = Δ cpi – Δ cpi* (relative to some base year). Annual depreciation = π - π* .   Prof. Jeffrey Frankel, Harvard Kennedy School

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

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: Band <= barriers Random walk <= shifts in terms of trade Trend <= Balassa-Samuelson effect Autoregression <= sticky prices . Q Q Band Random Walk Q Q Autoregression Trend 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 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? ” Business Review, Fed,Res,Bank of Philadelphia, Q2. Table 2. 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

Why is the price of Big Macs Jan.22, 2014 Why is the price of Big Macs so high in Norway & Switzerland? 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 => PNTG ↑ => CPI ↑ => (E P*/CPI)↓ , Or E ↓ 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, “Why are Goods So Cheap in Some Countries? ” Bus.Rev, Fed.Res. Bank of Philadelphia, Q2. Fig.1

UK inflation during Bretton Woods era Sticky goods prices => autoregressive pattern in real exchange rate (though you need 200 years of data to see it) Thatcher appreciation 1925 ₤ return to gold 1990: ₤ entered EMS 1931, 49, 69 ₤ devaluations 1992: ₤ left EMS UK inflation during Bretton Woods era ITF-220 Prof.J.Frankel

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 take into account that prices adjust, closing about ¼ gap per year. In the Long Run, prices may adjust fully, returning us to a LR PPP equilibrium, although even in the LR there can be changes in , E.g. from exogenous changes in terms of trade Or from Balassa-Samuelson effect. ITF-220 Prof.J.Frankel

Long distance transport costs fell sharply during Appendix 1: 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 2: 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

Big Macs were still expensive in Europe and cheap in China; 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

Balassa-Samuelson 1/Q relationship Source: “The Purchasing Power Parity Puzzle,” by Kenneth Rogoff, Journal of Economic Literature (1996). ITF-220 Prof.J.Frankel