International Parity Conditions: Purchasing Power Parity 44 Prices and Policies Second Edition ©2001 Richard M. Levich International Financial Markets McGraw Hill / Irwin

4 - 2 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4 - 3 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4 - 4 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4 - 5 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved.

4 - 6 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  The Usefulness of Parity Conditions in International Financial Markets  An Overview of International Parity Conditions in a Perfect Capital Market  Purchasing Power Parity in a Perfect Capital Market  The Law of One Price  Absolute Purchasing Power Parity  Relative Purchasing Power Parity  The Real Exchange Rate and Purchasing Power Parity

4 - 7 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  Relaxing the Perfect Capital Market Assumptions  Transaction Costs  Taxes  Uncertainty

4 - 8 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  Empirical Evidence on Prices and Exchange Rates  Empirical Methods, or How to Test a Parity Condition  Evidence on the Law of One Price  Relative PPP: Evidence from Recent Quarterly Data  Relative PPP: Evidence from Hyperinflationary Economies  Relative PPP: Evidence from Long-Run Data  Empirical Tests of PPP: Is the Real Exchange Rate Constant?  Empirical Tests of PPP: The Final Word

4 - 9 McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Overview  Policy Matters - Private Enterprises  The Role of Parity Conditions for Management Decisions  Purchasing Power Parity and Managerial Decisions  Purchasing Power Parity and Product Pricing Decisions  Policy Matters - Public Policymakers

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets  Parity conditions can be thought of as international financial “benchmarks” or “break- even values”.  They are the defining points where the decision- maker is indifferent between the two strategies summarized by the two halves of the parity relation.  Because parity conditions rely heavily on arbitrage, a violation of parity often implies that a profit opportunity or cost advantage is available to the decision-maker.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets  We begin our analysis of international parity conditions by assuming a perfect capital market (PCM) setting:  no transaction costs  no taxes  complete certainty  Based on the PCM assumptions, there are four principle parity conditions in international finance, of which only three are independent.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets 1a. Purchasing Power Parity Absolute Version The price of a market basket of U.S. goods equals the price of a market basket of foreign goods when multiplied by the exchange rate. Driven by arbitrage in goods.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets 1b. Purchasing Power Parity Relative Version The percentage change in the exchange rate equals the percentage change in U.S. goods prices less the percentage change in foreign goods prices. Driven by arbitrage in goods.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets 2. Interest Rate Parity The forward exchange rate premium equals (approximately) the U.S. interest rate minus the foreign interest rate. Driven by arbitrage between the spot and forward exchange rates, and money market interest rates.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets 3a. Fisher Parities Fisher Effect (Fisher Closed) For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation. Driven by desire to insulate the real interest against expected inflation, and arbitrage between real and nominal assets.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets 3b. Fisher Parities International Fisher Effect (Fisher Open) For two economies, the U.S. interest rate minus the foreign interest rate equals the expected percentage change in the exchange rate. Driven by arbitrage in bonds denominated in two currencies.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. The Usefulness of Parity Conditions in International Financial Markets 4. Forward Rate Unbiased Today’s forward premium (for delivery in n days) equals the expected percentage change in the spot rate (over the next n days). Driving force: Market players monitor the difference between today’s forward rate (for delivery in n days) and their expectation of the future spot rate (n days from today).

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market  Purchasing power parity (PPP) is built on the notion of arbitrage across goods markets and the Law of One Price.  The Law of One Price is the principle that in a PCM setting, homogeneous goods will sell for the same price in two markets, taking into account the exchange rate.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market  Let P US and P UK represent the weighted average price level for goods in the U.S. and U.K. market baskets respectively.  Absolute PPP predicts that these two price measures will be equal after adjusting for the exchange rate: P US = S $/£  P UK  Absolute PPP requires that the consumption baskets are identical across the two countries.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market Suppose absolute PPP is violated. Introduce K so that: P US, t +1 = K  S $/£, t +1  P UK, t +1 (a) P US, t = K  S $/£, t  P UK, t (b)  p US = s + p UK + s  p UK For small % changes, or when continuous rates are used, the cross-product term s  p UK can be ignored. %  exchange rate = %  U.S.prices – %  U.K.prices

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market  Often, we are interested in the level of the exchange rate that satisfies PPP.  The PPP spot rate reestablishes PPP relative to a base period. It is the exchange rate that would just offset the relative inflation between a pair of countries since the base period.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market Example Base period nominal exchange rate = $1.50/£ Prices of U.S. goods had risen by 8% Prices of U.K. goods had risen by 4% PPP spot rate = $1.50/£  1.08/1.04 = $1.5577/£  A nominal exchange rate of $1.5577/£ would reestablish PPP in comparison to the base period.  Nominal exchange rates greater than $1.5577/£ represent £ “overvaluation” ($ undervaluation), while rates less than $1.5577/£ represent $ “overvaluation” (£ undervaluation).

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market PPP conditions do not imply anything about causal linkages between prices and exchange rates or vice versa.  Both prices and exchange rates are jointly determined by other variables in the economy.  PPP is an equilibrium condition that must be satisfied when the economy is at its long-term equilibrium.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market  Real magnitudes are constructed from nominal magnitudes by adjusting for the appropriate price levels or inflation rates. Example Nominal income in 2000 (base year) = $55,000/year Real = $55,000 /year = 220 market baskets/year income $250 /market basket Nominal income in 2001 = $60,500/year Real = $60,500 /year = mkt baskets/year income $270 /market basket Index (2001) = /220 =

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market  The real exchange rate is calculated by correcting the nominal exchange rate for the price levels in the two countries.  When absolute PPP holds: $1.50/£ = $1,500/US good. £ 1,000/British good LHS = 1 US good / British good RHS  When PPP holds, the real exchange rate is constant.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Purchasing Power Parity in a Perfect Capital Market  An index of the real exchange rate is defined as: Spot (Real, t) = Spot (Nominal, t). Spot (PPP, t) Example Today’s spot exchange rate is $1.80/£ PPP spot rate is $1.50/£ Real exchange rate index = 1.80/1.50 = 1.20  At 1.20, the £ is “overvalued” on a PPP basis. 1.0 British good can be exchanged for 1.2 U.S. goods. So, sellers of British goods have “lost competitiveness” on international markets.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Relaxing the Perfect Capital Market Assumptions  Transaction Costs  Transport and menu costs lead to a neutral band around the PPP line, within which it is not profitable to execute arbitrage transactions.  Taxes  Tariffs have an effect similar to transaction costs.  Uncertainty  Arbitrageurs will seek a greater profit to compensate for risks, thus leading to a wider band around the PPP line before arbitrage becomes profitable.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates  A parity condition can be viewed as a 45° line passing through the origin with the LHS and RHS variables plotted on the x and y axes.  Thus, parity conditions can be tested by running the simple linear regression: LHS t =  +  RHS t +  t  Parity holds when the data cannot reject a null hypothesis where  = 0,  = 1, and the error terms have classical properties.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates  In reality, seemingly “homogeneous” goods may differ in a number of important respects which undermine tests of the Law of One Price.  One test of the Law of One Price is the Big Mac index, which has been published annually in The Economist since  It was devised as a light-hearted guide to whether currencies are at their “correct” level, based on PPP.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates Source: The Economist, April 29, 2000 Switzerland Britain South Korea France Argentina Euro Area Taiwan Italy Canada Indonesia Brazil Thailand Hong Kong Russia Hungary Malaysia Ratio of Big Mac Prices in US$ Relative to U.S. Price U.S. Price is $2.51/Big Mac

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates  With the rise of e-commerce, investigating the Law of One Price becomes easier and violations more puzzling.  A recent Wall Street Journal article highlighted the case of a popular book that sold for $16.20 at Amazon.com (U.S.), for $13.52 at Amazon.co.uk (Britain), and for $27.00 at Amazon.de (Germany).

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates  To examine the relative PPP condition, we can compare the exchange rate change to the contemporaneous inflation differential: s t =  +  (p $ – p DM ) t +  t  It seems that PPP is a poor explanation of exchange-rate changes on a period-by-period basis.  However, there is a tendency for PPP to reassert itself as time passes (mean reversion).

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Quarterly Deviations from Relative PPP CPI: Germany and the United States, (US-German) Inflation Spot Rate Changes  =  = 0.15 R 2 = N = 107 (0.007) (0.83) D–W = 1.83 % Deviations Average Inflation Difference

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates  During a hyperinflation period, even the demanding regression-style test tends to support PPP. This is due in some degree to dollarization.  Long-run data indicated that the real exchange rate did not evolve as a random walk, but demonstrated a clear tendency to revert back to its central value.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates  Note that the real exchange rate itself may not be constant.  It may change on a permanent basis if a real shock affected one country but not its trading partners.  The Balassa-Samuelson hypothesis states that countries that have experienced high productivity gains, higher real income growth and higher real incomes should have appreciating real exchange rates.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Empirical Evidence on Prices and Exchange Rates  Empirical tests confirm that...  PPP is a poor descriptor of exchange rate behavior in the short run, where the rates are quite volatile and domestic prices are somewhat sticky.  But in longer-run analysis, it appears that PPP offers a reasonably good guide.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Private Enterprises  If managers can identify the deviations from parity that are growing larger or likely to persist, then profit-maximizing decisions can be made.  Knowing that deviations from parity occur, managers may adopt strategies that reduce their exposure to the risks of such deviations.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Private Enterprises  In a number of instances, international price differentials in some commodities have been both large and persistent.  More interesting perhaps are the international price differentials across “branded goods” like McDonald’s Big Mac and The Economist, whose prices are set by brand managers rather than by market forces.

McGraw Hill / Irwin  2001 by The McGraw-Hill Companies, Inc. All rights reserved. Policy Matters - Public Policymakers  Deviations from PPP, by definition, measure changes in a country’s international competitiveness, and reveal whether a currency is overvalued or undervalued relative to a simple standard.  However, there are limitations on the usefulness of PPP in policy decisions, as real macroeconomic disturbances call for a change in the real exchange rate.