1. Tests of the Law of One Price –NTGs –Commodities –Manufactures –Big Mac hamburgers –Imports Barriers to International Integration – Transportation costs – Tariffs & non-tariff trade barriers – Border frictions – Currencies N on - T raded G oods -- The Balassa-Samuelson Effect Lecture 9: FAILURES OF PURCHASING POWER PARITY (PPP)

2. API-120, Prof.J.Frankel, Harvard Kennedy School Tests of the Law of One Price (LoOP) 1.Internationally Traded vs. NonTraded Goods & Services, e.g., haircuts & housing; little scope for arbitrage. 2.“Customer goods” vs. “auction goods, ” agricultural & mineral commodities -- where arbitrage works well. 3.Disaggregated manufactures e.g., Giovannini (1988), Engel (1993). 4.In reality, even TGs have a NTG component (distribution & retail), & vice versa. - Some recent models make the TG/NTG line endogenous: Bergin (2003); Ghironi & Melitz (2004) - McDonalds hamburgers. The Economist (1986- ), Parsley & Wei (2003). 5.Pass-through of import prices. Big recent literature.

3. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Prices of nontraded services vary widely. Notice that they are lower in poorer (low-wage) countries than in high-wage countries. NTGs

4. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University For a homogeneous mineral commodity such as gold, international arbitrage equalizes prices quite closely. Commodities Kenneth Rogoff, “The Purchasing Power Parity Puzzle, J. Ec.Lit., 1996.

5. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Even in a manu- facturing sector as disaggregated and seemingly standardized as ball bearings, the relative price in Japan varies Manufactures (1)widely, and (2)in correlation with the ¥/$ exchange rate. Alberto Giovannini. “Exchange Rates and Traded Goods Prices,” J.Int.Ec.,1988.

6. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Big Macs are partly traded (ingredients) & partly nontraded (cooking & retail). Their price varies widely across countries. The price tends to be higher in rich countries ( e.g., Europe & Japan), than in developing countries ( e.g., China) and in countries with overvalued currencies ( e.g., Argentina in 2000). Big Mac s

7. Pass-through coefficient ≡ % change in local price resulting from a given % change in exchange rate. Pass-through is greatest for imported goods at dock, but less for prices of the same goods at retail level. Reason: local distribution & retail costs. The passthrough to prices of local substitutes is again less; and is still less to the CPI. 76 developing and other countries, 1990-2001 Source: Frankel, Parsley & Wei (2012) Pass-through to import prices

8. Passthrough coefficients for less developed countries > for rich, historically. Source: Frankel, Parsley & Wei (2012 )

9. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University BARRIERS TO INTERNATIONAL INTEGRATION OF GOODS MARKETS Transportation costs Tariffs & non-tariff trade barriers Border frictions Currencies NON-TRADED GOODS (NTGs) The Balassa-Samuelson effect Deviations from the Balassa-Samuelson line

10. Long distance transport costs fell sharply during the late 19th century.

11. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University By 1914, low transport costs, free trade in the UK, & the Pax Brittanica, allowed arbitrage between the US & UK in wheat.

12. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University In agricultural products, high trade barriers are still retained, preventing price arbitrage.

13. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University CROSS-BORDER TRADE BARRIERS: KEY FINDINGS (after controlling for trade policy & geographic variables) Even across the Canadian- U.S. border, Looking at trade among large sample of countries, Gravity model of volume of trade shows: firms trade with fellow citizens 20 x as much as cross-border (5-10 x, after controlling for FTA, etc.) -- McCallum (1995), Helliwell (1998) ; different currencies, in particular, cut trade sharply -- Rose (2000); Evidence of arbitrage in price differentials shows: frictions in crossing the border >> frictions in going from one end of country to the other -- Engel & Rogers (1996). different currencies, in particular, explain some of the border frictions -- Parsley & Wei (2001)

14. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Engel & Rogers “How Wide is the Border?” AER (1996) Crossing the border, e.g., from Vancouver to Seattle, adds more friction into price arbitrage than traveling the length of the continent from Atlantic to Pacific.

15. Copyright 2007 Jeffrey Frankel, unless otherwise noted Rose (2000), the most influential empirical paper in international monetary economics in the last 12 years: Applying the gravity model of bilateral trade to a large sample of countries reveals (exp(1.2)=3). not only that a reduction in bilateral exchange rate variability encourages trade, even after controlling for common colonial history, etc., but that joining a currency union results in an estimated tripling of trade among the partners.

16. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University NonTraded Goods & Services Why is the cost of living so high in Tokyo and so low in Mumbai? Why was Buenos Aires more expensive than Paris or Frankfurt in 2001?...

17. In 2004, Tokyo was still very expensive. But Buenos Aires had fallen far below Paris or Frankfurt. Why? The peso collapsed in 2002.

19. One important application of the TG-NTG model, particularly for long-run trends. The Balassa- Samuelson effect: (P NTG /P TG ), and therefore Q, riseswith countries’ real incomes. Usual B-S reason: Productivity growth takes place in the TG sector, reducing prices there relative to wages and P NTG. Original Balassa article (1964)

20. Distinguishng TGs from NTGs is difficult in practice. Estimates of tradability calculated for about 200 products, as the worldwide trade/output ratio, relative to average tradability of all products Source: Robert E. Lipsey & Birgitta Swedenborg, 2010, Review of World Economics. http://www.nber.org/papers/w13239 http://www.nber.org/papers/w13239 Data: 20 OECD countries, 1985-1999, from UNIDO (2000) & US.Commerce Dept. (2002). Tradable goods Non- Tradable Goods

21. In almost all countries, the ratio of NTG prices to TG prices rises over time (the “Baumol effect”). Japan had the strongest trend during the post-war period. If more than 2% of the sector is traded, it must be tradable.

22. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University The original Belassa article showed 1960 levels.

23. The countries with the strongest productivity growth tend to show the strongest upward trend in the relative prices of NTGs (1970-1985).

24. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Rogoff (1996): Again, countries with high incomes per capita tend on average to have high real currency values, as judged by absolute PPP.

25. API-120 - Macroeconomic Policy Analysis I, Prof.J.Frankel Balassa-Samuelson relationship re-estimated Every 1% increase in real income/capita is associated on average with.38% real appreciation. In any given year, many countries lie far off the line. E.g., China’s RMB appears “undervalued,” even relative to the B-S relationship. –Chang (2011) estimates 25 % on 2009 ICP stats. What causes currencies to deviate from the B-S line? –Devaluation/revaluation –Fixed nominal exchange rate plus either inflation or rapid productivity growth Gaps from the B-S line tend to correct 1/2-way per decade.

26. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Balassa-Samuelson estimated for 2000 Cross-section of 118 countries Frankel (2006): “On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,” Understanding the Chinese Economy, G.Illing, ed. (Oxford U. Press). Log of real exchange value of country’s currency (1/Q) Log of real income 3 paths to an “undervalued” currency: (i) devaluation, (ii) low inflation, (iii) fixed exchange rate during a long period of rapid productivity growth.

27. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University

28. APPENDIX 1 -- PASSTHROUGH Jose Campa & Linda Goldberg (2005) Passthrough of exchange rate changes to import prices is low into the US market (especially in the SR). But for most other countries, the passthrough coefficient is above 50% even in the SR, and not statistically different from 1 in the LR. In most, the coefficient fell during the 1990s. Compositional differences of price indices (e.g., more weight on oil vs. autos) can alone explain part of the variation in passthrough coefficients. The passthrough coefficient depends on inflation & exchange rate volatility.

29. Jose Campa & Linda Goldberg, 2005, “Exchange Rate Pass Through into Import Prices," Review of Econ. & Stats. 87, 4: 679-90.

30. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Estimates from Jeffrey Frankel, David Parsley, & Shang-Jin Wei, 2012, "Slow Pass-through Around the World: A New Import for Developing Countries?” Open Ec. Rev., 23(2): 213-51.

31. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University Appendix 2: Updated estimate of real valuation measured relative to Balassa-Samuelson Source: Gene Chang (Aug. 2011)

32. Copyright 2007 Jeffrey Frankel, unless otherwise noted API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University APPENDIX 1 – Balassa- Samuelson relationship China: 25% undervaluation Estimate of over valuation /undervaluation measured relative to the Balassa-Samuelson line Source: Gene Chang “Theory and Refinement of the Enhanced-PPP Model for Equilibrium Exchange Rates,” Aug. 2011.

33. Appendix 3 : Emerging markets show trend real appreciation over 16 yrs. Evidence of Balassa-Samuelson effect; but fixed exchange rates, devaluation, or money growth can create big short-run deviations from the trend.