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The Purchasing-Power Parity Doctrine: A Reappraisal

Author(s): Bela Balassa
Source: Journal of Political Economy, Vol. 72, No. 6 (Dec., 1964), pp. 584-596
Published by: University of Chicago Press
Stable URL: http://www.jstor.org/stable/1829464
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De- 4 F. 1 [Prince- associated with the relative interpreta- ton.J. It may be of interest. spectability. pp.S. 1944 (reprinted in Foreign Economic Policy for the United States. for example. E. 19611). A Survey Although his name has come to be of International Trade Theory (rev. "Exchange Rate Adjustment. Interest in the doc- therefore. "Abnormal Deviations in Inter- hypothesis by arguing that "the rate of national Exchanges. In the following. Cassel also formulated the absolute 2 Gustav Cassel. THE PURCHASING-POWER PARITY DOCTRINE: A REAPPRAISAL BELA BALASSA Yale University I statistical material has become available that has a bearing on the relationship 5_HIE purchasing-power parity doc- between purchasing-power parities and trine has had its ebbs and flows exchange rates. November. Power Parity. "The Choice of Exchange United States Balance of Payments (Washington: Rates after the War. S. the relative interpretation of the made to clothe the purchasing-power doctrine asserts that. 304. "A Note on determined by the quotient between the Fundamental Disequilibrium. International Trade (New York. 46-47.5 but it has pair of countries would tend to approxi- managed to survive nevertheless. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . search began for the elusive concept of The purchasing-power parity doctrine equilibrium rates. exchange between two countries will be I Cf.' two versions of this theory that can be it received its christening at the hands appropriately called the "absolute" and of Gustav Cassel during World War I. ed. change rates. pur- II. in comparison to a parity doctrine in the garments of re- period when equilibrium rates prevailed. W.. 287- Tune. B. 1958. N. H. ed. new II 1 For references. pp. Princeton tion of the purchasing-power parity doc- University.3 It has also had its critics. pp. A. Congress Joint Economic Committee). Houthakker. see Gottfried Haberler.2 the "relative" interpretation of the doc- and it was resurrected after World War trine. It was first invoked- means different things to different peo- although in somewhat ambiguous terms ple. and further writings cited below. among chasing-power parities calculated as a others Taussig after World War J4 and ratio of consumer goods prices for any Haberler after World War IJ. chap." American Economic Review.194.: International Finance Section. Mass. I shall deal with -in the period of the Napoleonic wars.." No. to reexamine the claims put in trine arose whenever existing exchange for the validity of the purchasing-power rates were considered unrealistic and the parity doctrine. and H.." Review of Economics general levels of prices in the two coun- and Statistics. new efforts have been In turn. 1945. "A Rehabilitation of Purchasing- Harris [Cambridge.6 At the same time. Hansen. "Special Papers in International Economics.252. 516-30. U. xxvi. According to the first version. In recent years. 19481). Taussig. S. September. and a proposal has also been changes in relative prices would indicate put forward to use this doctrine as a the necessary adjustments in exchange guide in establishing equilibrium ex- rates. 1927)." Economic Journal. 584 This content downloaded from 129. mate the equilibrium rates of exchange. 1918. Yeager. 6 L. trine.40 on Mon. I over the years." Factors Affecting tle 6 Gottfried Haberler." Journal of Political Economy. cember.

"7 Further. .. the relative price of the Dutch guilder. First.S. Under the itself is overvalued. equalized in the two countries through See also The World's Monetary Problems (London: Constable.. who has expressed the opin. and constant dollar. 28 (cited in 9 "Exchange Rate Adjustment. greatly undervalued. 1958]. dollar appears to be overvalued as facturing products) than for the non- compared to the German mark." Economic Journal. cit. rate was 0. 62. when one overvaluation of the dollar which can of the countries has an absolute advan- certainly not be wholly attributed to tage in the production of all commodities statistical defects of the calculation. Since the prices of traded goods are 8 "Abnormal Deviations ."9 but this advantage is greater in regard Houthakker also argues that. pp. "The Present Situation of the Foreign Exchanges. 298. the mark traded commodity (services). let us amend the traditional two-country..or undervaluation of individual of exchange rates and purchasing-power currencies. This implies a very substantial input coefficients a la Ricardo.11 Now. icy." op. 413. two- that "in terms of purchasing power the commodity model of international trade dollar is now [in March.252. 1916. 21. 36. the absolute interpre. 8-9. Kindleberger." in Foreign Investments. ion that the relative price levels of con. pp. given that takes place. the actual rate of exchange Houthakker proposes to correct the al- cannot deviate very much from this pur. the ratio of long as anything like free movement of purchasing-power parity to the exchange merchandise and a somewhat compre. p.. labor."8 by devaluation. ductivity levels than in the other. 1928). p." op. the Danish crown. while the to traded goods (agricultural and manu- U. the corresponding ad- Most recently. 84th Cong. March. Relying on purchasing-power parities. Since this recom- Houthakker.. justment would entail a substantial tation of the purchasing-power parity appreciation of the currencies of the doctrine has been invoked by Hendrick developing countries. Assume further the existence change rate of 4 German marks to the of one limiting factor.S. and the Austrian assumption of constant marginal rates shilling. their resented by [the] quotient between the currencies would generally appear to be purchasing power of money in one coun. 297.40 on Mon. According to calcu- try and the other. PURCHASING-POWER PARITY DOCTRINE 585 tries. C. "at every moment the If we were to apply this principle also real parity between two countries is rep. p. p. mendation can hardly be taken seriously. Hearings. Millikan.. and especially of transformation. Economic Policy of the Joint Committee on the Lectures on the Harris Foundation (Chicago: Uni- Economic Report. and "The International 11 Statement before the Subcommittee on Foreign Movements of Capital. to the less developed countries. cit.27 hensive trade between two countries for Africa in 1950.. the question arises what meaning can be sumer goods provide an indication of the attached to an international comparison over. Economic Development [New 10 Ibid. F. York: McGraw-Hill Book Co. P. undervalued. dollar chasing power parity. p. in com- parity 'the purchasing power parity. dollar. 1921).S. pp. 1st sess. 2-3).' As parison to the U. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . Houthakker concludes various levels of abstraction. I propose to call this lations made by M.29 for southeast Asia and 0. This content downloaded from 129. leged overvaluation of the U. 1962] worth 22 theory by introducing a non-traded good cents less than it is at the official ex- (services). parity calculations made by the German This question can be answered at Statistical Office.194.10 the non-traded commodity will thus be higher in the country with higher pro- 7Gustav Cassel. 1955. Foreign Economic Pol- versity of Chicago Press.

will be comes are taken as representative of lower than the equilibrium rate of ex- levels of productivity. the purchasing- differences in the sector of traded goods power parity between the currencies of will correspond to productivity differen- the two countries. If per capita in- with higher productivity levels. According to the latter. with allowance made for prices in terms of wage units. sector than in the production of traded goods. expressed appear to be overvalued in terms of pur- in terms of the currency of the country chasing-power parity.586 BELA BALASSA international exchange. can also be formulated in terms of abso. the rela- those implicit in the absolute interpreta- tionship shown under equation (2) can tion of the purchasing-power parity doc- be obtained if we retain the assumption trine. Still. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . and wages equalized within each 2.p2q. spondingly. while the above dis- tor. will be less than the parable labor within each economy. of payments. this proposition a) In the absence of trade restrictions.194. transportation costs. chasing-power parity to the exchange e) The greater are productivity differ- rate will thus be an increasing function entials in the production of traded goods of income levels.40 on Mon. defined as the ratio tials. the following reasoning can since higher wages will raise the relative price of be applied.12 the assumption of constant coefficients These results can now be compared to in production is relaxed. the larger will be differences in wages and in the prices of PP1 = F ( Y21) (2 ) ri services and. Corre. the pur- traded goods. additional er parity and the equilibrium exchange factors of production are introduced and rate. by expressing of traded goods. This content downloaded from 129. the ratio of pur- change. the currency of the country chasing-power parity between the cur- with the higher productivity levels will rencies of any two countries. while the internal mobility of labor of the price level of the second country will tend to equalize the wages of com- to that of the first. correspondingly. whether or not we use the b) Under the assumption that prices first or the second country's consumption equal marginal costs. services will be relatively more Xpl ql Xpl q2 expensive in countries with higher levels In other words. < r2 9 and 2P2< j2 (1) country. purchas- that international differences in produc- ing-power parities calculated for any pair tivity are greater in the sector of traded of countries would tend toward equality goods than in the non-traded goods sec- with exchange rates. services in countries with high levels of productivity. Assuming that invisibles and capi- 12 This conclusion is further strengthed if we con- tal movements do not enter the balance sider that services are relatively labor-intensive. intercountry wage- patterns as weights. between two countries. for instance.252. expressed c) With international differences in in terms of the currency of the first productivity being smaller in the service country. assuming that inter- of productivity. the greater will be the gap between purchasing-pow- In a more general model. Thus. the exchange rate will equate the prices lute prices. equilibrium rate of exchange. national productivity differences are d) Since services enter the calculation greater in the production of traded of purchasing-power parities but do not goods than in the production of non- directly affect exchange rates.

tries. and laundry III and drycleaning about the same. to groups of services for which informa- If differences in tastes do not counter. 1963. although this average lacks of purchasing-power parities being ran. This content downloaded from 129.252. PURCHASING-POWER PARITY DOCTRINE 587 cussion points to the existence of sys- vestigation of several industrial coun- tematic differences between purchasing. the arguments of the present paper household services in the United States lead us to expect random deviations to and Italy for the year 1950. and overesti- Review of Economics and Statistics.S. B. domly distributed around exchange rates The importance of weighing can also -at least in the short run. It is customary to use a geo- weighting. States are shown in columns (3) and (4) ities by using some standard system of of Table 1. At the In attempting to provide an empirical same time. 14-30. This re- Review of Economics and Statistics. been the cornerstone of my exposition. on rates. "An Empirical Demon- mated if the weights are the final bill of stration of Classical Comparative Cost Theory. Gilbert and I. in the United States. ber problem. Balassa. been obtained in an in- p. the absolute interpretation of metric average of the two values in em- the doctrine would admit the possibility pirical work. August. barber and beauty shop services one-fourth. balance differences in productive endow.194. pp. tion is available. alent for household services was 391 cerning the relationship of purchasing lira at U. After conversion at exchange ing-power parities to exchange rates. weights. and per capita income to have cost one-fifth of the amount paid levels. Kravis.13 the data appear to bear out my Correspondingly. Were of the two measures in a comparison of we to express exchange rates in terms of European economies and the United gold and calculate purchasing-power par. "Wages and Foricgn Trade. there will be a tendency in each evidence on the tendency for interindus- country to consume commodities with try wage equalization in individual coun- lower relative prices in larger quantities. Taken in conjunction with available ments. weights and 165 at Italian parities.40 on Mon. ity differences in the service sector are estimated. February. in fact. as given in occur around a curve indicating the rela- a study by M. domestic services in Italy appear the one hand. in these calcula. the final bill of goods consumed in 1950 are shown in Table 3 with regard individual countries. B." pattern is used as weights. The results will depend on Ratios between purchasing-power equiv- the choice of weights-in the present alents and exchange rates for the year case. 625 lira to the dollar. 238. on the other. as against the exchange rate of els. if Country I's consumption 18 I. By reason of inter- Kravis further provides evidence of the country differences in productive en. By compari- be seen in a comparison of the cost of son. the purchasing power contention that international productiv- of Country II's currency will be under. tion of purchasing-power parities need Information provided by Gilbert and first to be considered. Kravis tionship between the ratios of purchas- (Table 2). The estimates derived by the use power parities and exchange rates. exchange rates. tries with higher income levels that has tions we face the well-known index-num. sult has. 1956. some questions regarding the calcula. a specific economic meaning. relatively high cost of services in coun- dowments and tastes. tries. the purchasing-power equiv- verification of the above proposition con. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . and income lev. and B." goods consumed in Country II.

Canada: Wirtschaft und Sluaistik (1962).. 86. 1963.5 100.84 5. . In Italy. excepting Canada.. Italian Quantity Quantity Quantity Quantity Weights Weights Weights Weights Domestic services .. and Norway: I... 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . TABLE 1 PURCHASING-POWER PARITIES FOR GROSS NATIONAL PRODUCT IN 1960 (National Currency per U.Per Rate Weights Weights and (4) change Rate Capita 100X(5) (2) (1) (2) (3) (4) (5) (6) (7) United States.2 80. total .51 66.252... p. Dollar) Purchasing- .171 3...0 2051 Canada .. This content downloaded from 129.S.2 28.23 3.. 113-20.. 327-29..225 0..9 1200 ItalyL ..Krona 7. sons of the United States and Europe.. while for Germany and the Netherlands and within Europe services are by and the corresponding figures were 38-43 per large cheaper in countries with relatively cent.906 6.Krona 5..6 26. p...1 704 Netherlands.4 1273 France .8 Laundry. France. Dollar 1 1 1 1 100..5 40..588 BELA BALASSA considerably smaller than in the produc..Dollar 0.06 4. 445. ..... .4 1269 Norway .903 4.." Journal of Political Economy.357 0.194.. pp... 4.6 507 Source: All countries.S. ...Mark 4....996 ... .. the country with the lowest tion of traded goods. Kravis and Michael W..0 44.S.338 0.. .4 1186 Sweden . B.921 92..4 Source: Milton Gilbert and I..70 5.6 574 330 435 70.96 2...74 80. 225 62.8 1550 Belgium .. Pound 0..Franc 4..770 2.6 ... Belgium. on the average. and for the remaining group of low incomes.. 1954). S. Kravis. ~~~~~Geometric Power Parity Currency Official At U.8 21. services cost. F Ilorin 3.. dry cleaning. Dollars) PURCHASING-POWER PURCHASING-POWER P QURCHASING-POWR EQUIVALENT AS A PERCENT- AGE OF ExCHANGE RATES U. Davenport. B..... pp.......25 77... Belgium and Norway: our estimate derived from Milton Gilbert and Associates.. and national statistics.6 1166 United Kingdom .2 Household and personal serv- ices..Krona 6. 628 628 100. . 0...180 .. 1958). .40 on Mon.Income Country Currency Exchange Quantity Quantity Mean of er .F ranc 50...... Comparative National Prod- ucts and Price Levels (Paris: OECD...47 3..13 2..... cost of services in high-income countries.4 36..ira 620.66 90...4 1152 Germany ..0 1307 Japan ....S.S.5 Barber. countries (Belgium. Italian U.. 391 165 62.4 1212 Denmark ..81 4. raising thereby the income levels among those considered.34 77... TABLE 2 PURCHASING-POWER EQUIVALENTS IN HOUSEHOLD AND PERSONAL SERVICES IN 1950: UNITED STATES AND ITALY (Lira per U.. Denmark.294 82. An International Comparison of National Products and the Purchasing Power of Currencies (Paris: OEEC. one-third A uniform pattern is shown in compari...Yen 359. August.143 6. At National Meoa of as a Percent... .73 3. 136 136 21. 176 176 28.86 2.. . beauty shop . "The Political Arithmetic of International Burden-Sharing. of their cost in the United States in 1950.80 77. .

.. 47. and and overvaluations of a few percentage especially in the United Kingdom. for example. 90. Comparisons of pur- other. con- sidering that in various European countries.3 27..4 Health . the only exception being recrea.. And whereas the I have suggested above that the higher application of the purchasing-power par- level of service prices at higher income ity doctrine is seen to give incorrect an- levels leads to systematic differences be.6 32. the observed relationship between purchasing-power parities and equilibrium exchange rates. on the valuations followed in rapid succession one hand.5 38.7 45. 1950* Belgium Denmark France Germany Italy Netde| Norway Kingdom landsKigo GNP per capita ($) ...S..1 75.2 66. pD.S.. 65.. hence the magnitude of the re- rationing and price controls still affected prices in quired revaluation.7 55..2 45. and given-country weights....1 62.1 Public transport services... than average prices indicated by GNP The empirical results provide evidence deflators in the countries of western for the validity of my proposition regard- Europe....5 50. and a geometrical average of the results has been taken. Source: Milton Gilbert and Associates..4 42..3 47....194.4 84.5 Government administra- tive personnel . swers for determining equilibrium ex- TABLE 3 PURCHASING-POWER EQUIVALENTS FOR SERVICES AS A PERCENTAGE OF EXCHANGE RATES...... 75-80..0) 19. statistically prices of all services were relatively lower significant at the 2 per cent level.. 26. I have made a comparison as to the overvaluation or undervalua- for twelve industrial countries between tion of a currency. dollar. on the in 1957 and 1958. ing the relationship between purchasing- tion and entertainment in Belgium and power parities... exchange rates..4 33.3 56.9 19. and indeed two de- product) to the rate of exchange.9 54. This content downloaded from 129.. 1950.7 48. and per capita GNP. 30. capita income levels....3 71. however. tween purchasing-power parities and change rates... 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions .3 42.....8 40.3 37. in com..5 46.0 70....4 52...... 53.8 64.1 40.7 69..4 71. 7 Defense personnel .9 42.2 59. disclose under- 14 An exact correspondence is not expected....1 42.0 51. 956 989 831 650 418 798 929 995 Purchasing power equiva- lants: Household and personal services .7 27.0 (20.0 50.4 33.2 70.. 60. To test this exchange rates may provide some clue hypothesis... and Figure 1... 7 Services.7 16.9 44.3 20.7 51. indicate a positive correla- 63 per cent..8 36.2 68.5 65. 64.'4 At the same time. All calculations have been made at U..3 51. 63.... The cor- parison with the United States..6 61.8 41..9 34.2 59. .9 Recreation and entertain- ment .. A consideration of in- the ratio of purchasing-power parities formation given in Table 4 points to the (calculated in terms of national curren- overvaluation of the French franc in cies per U... and the United Kingdom) 41... Data for 1960.7 51...2 63....... Comparative National Products and Price Levels (Paris: OEEC. dollar for the gross national 1955.. the relation coefficient is 0. shown in Table 1 chasing-power parities and exchange rates will not..5 46. PURCHASING-POWER PARITY DOCTRINE 589 Norway. 1960)..4 47..40 on Mon. and per Norway (Table 3).0 53.4 18.1 * The original data are expressed in terms of national currencies per U.4 42.4 41.252.5 Education ..2 Grossnationalproduct . total .92.0 43. 81.1 51... the postwar points.S.6 36.. tion between the two variables...3 43.

.9 37. This content downloaded from 129..272 Netherlands .Franc 350 394 287 Germany .49.Krona 7.L.91 5...194.Mark 4. p.025 X (.80 293 2.. Lire 625 605 337 United Kingdom .78 Source: Milton Gilbert and Associates..358 0.003) 500 1000 1500 2000 PER CAPITA G. Comparative National Products and Price Levels (Paris: OEEC.14 6.N. Pound 0..590 BELA BALASSA IV degree of adjustment in exchange rates.6 France .20 3.S. it is a different sons be made with some previous period question whether changes in the relative taken as a norm. 1 TABLE 4 PURCHASING-POWER PARITIES FOR GROSS NATIONAL PRODUCT IN 1955 (Units of National Currency per U. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions .94 4.57 Norway .S.Franc 50.2 44.252.319 0. who have suggested that compari- appears unsatisfactory.58 4..40 on Mon.. Since the nineteenth century this propo- While the absolute interpretation of sition has been indorsed by several writ- the purchasing-power parity doctrine ers.Krona 6. 1958).51 2. 30. 17 Ienmark .34 +. European Quantity Quantity Weights Weights Belgium ..K.R FIG. purchasing power of national currencies This formulation of the purchasing- can provide an indication of the required 6 100 US cc (D CANADA j 90 SWEDEN x X 3 u U. X 80 NORWAY x XBEGU :LD 80 ji/GERMANY z XDENMARK <0 W 70 ITALY x FRANCE w / NETHERLANDS LLI 60 / JAPAN 50 Y.54 Italy . Dollar) PlrRCIHAsING-PowER PARITIES CURRENCY OFFICIAL ____ __ ______ COUJNTRY UNIT EXCIIANGE RA TE U.Florin 3.

that a correspondence tical instance where international com- between changes in purchasing-power merce has not come to a standstill. With changed empha- compare two equilibrium positions which sis. ods of war when the normal channels of such as Belgium and the Netherlands. The relative interpretation of the pur- greater interest attaches to comparisons chasing-power parity doctrine has been between countries that have a substan- advocated. the Netherlands is taken as the standard. since the postwar year the purchasing-power parity doctrine for chosen (1957) followed one or more de- determining the new exchange rates. B. Actually. runs] much more strongly from price post-World War II period.. changes can hardly be excluded. if this were off the mark by over the proponents of this doctrine empha- 25 per cent in one-fourth of the cases size the importance of the monetary fac- considered. but there is no supply and demand relationships.. cit. they son chosen. rates. it is not clear what its absolute version and can be stated as degree of statistical significance this a comparative-statics proposition: If we range represents. at the same time. following peri- tial amount of trade with each other. one may argue that the proposition differ only in regard to the absolute price is of little practical value since one-fourth levels prevailing in the two countries of the cases do not even come within the under consideration. p. for example. p. Indeed. one could equilibrium exchange rate will equal the hardly rely on the relative interpretation change in the ratio of price levels between of the purchasing-power parity doctrine the two positions. 17 Yeager. To support levels to exchange rates than the other this proposition. cit. tors and see the line of causation running At the same time. L. op. In claiming that this for determining equilibrium exchange proposition is applicable to the real world. G. the occurrence of structural hardly be said to support Yeager's thesis. changes in demand and supply rela- change rates and purchasing-power pari- tions will give rise to errors in applying ties is not clear."6 Yeager takes the United neglect changes in income levels and in States as this standard. fourths of the [35] countries shown. valuations in almost all of the countries Among the proponents of the purchas- under consideration. Yeager lem of causation will arise in every prac- argues. Johnson on this point. 522."'7 and uses two arguments that the "actual-to-parity ratio fell in- to support his proposition: that trade side the range 75-125 per cent for three- flows affect domestic prices only slightly. Thus. It should further be noted that the especially in the case of moderate infla- cause-and-effect relationship between ex- tion. a priori reason for this choice. the change in the 75-125 per cent range. the calculated range from the money supply to prices and to will depend on the standard of compari- exchange rates. 15 Yeager.2 for Belgium-a result which can such periods.194. the prob- ing-power parity doctrine. op.. 527.252. 161 I am indebted to H. PURCHASING-POWER PARITY DOCTRINE 591 power parity doctrine is independent of To begin with. he points to the fact way around. In fact."'5 and that movements in the general Drice But Yeager's alleged demonstration is open to serious objections. parities and in exchange rates is indicated Yeager suggests that "the causation by a comparison of the interwar and .. But even though monetary factors might the actual-to-parity ratio is calculated as have been of great importance during 156. This content downloaded from 129. If international trade had been disrupted. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . however.40 on Mon.

"23 But buying power of a country's currency is.18 crease the money supply. ed goods. Living in the United Kingdom." in Essays in Persuasion (1941). "the main reason for doubting that causation runs predomi- so quickly and would show a disparity if nantly from exchange rates to prices is that the equilibrium has not been reached. "Devaluation and the Cost-of- ence (Geneva: League of Nations. 1949 (1). p. 521 ff.20 British and American wholesale price in- dexes. there is no rea- The first argument appears to reject son to assume that velocity would remain marginal-cost pricing and to deny the unchanged. 49. 520). On the latter. pp. change was in the rate of exchange.40 on Mon. This content downloaded from 129. "the moral changes in the quantity shipped internationally amount to only a small fraction of the quantities ap- may seem to be that we should use an pearing on markets at home and abroad. and J. experts "miscalculated the degree of mal- ditions of full employment increased de. "Ex- of Mr. 288-322. There of changes in wholesale prices is made.592 BELA BALASSA level are determined basically by changes Should the authorities be unwilling to in- in the money supply. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . p. p.. pp. bring about immediate adjustments in Nurkse cites the case of Czechoslovakia the case of international price differences in the nineteen-twenties when the degree due to differing rates of domestic infla. inflation. Haberler of inflation have relevance after a deval. pp. L..252. Churchill. cit.. According to Haberler. and the 248.194.) incorporating traded as well as non-trad- 19 Cf. quotes Keynes's remark that Churchill's uation has taken place. determined by the quantity of money and the demand for cash balances. Financial Policy. change Depreciation. Such a model has been used in 20 Cf." (Ibid. see J. Domestic Price Level. M. above all Haberler adds that structural changes else. p. "The Economic Consequences Studies. Keynes. In the absence of changes may greatly affect the balance of pay- in the money supply. cited in Haberler.22 18 "A minor reason is that. ibid. ibid. index was heavily weighted with traded duced" inflation implies the acceptance goods." International Monetary Fund Staff Papers. for many commodities. April. op. is a curious asymmetry here: while Yea.. pp. Liege. adjustment of money values which would mand for the country's exports as well result from restoring sterling to its pre- as the higher costs of imports is bound war gold parity" by comparing the to lead to domestic price increases. relevant if an international comparison tion of the prices of traded goods. Further. so that index of domestic prices (cost of living) changes in trade flows may affect domestic prices or of costs (wages) which do not adjust only slightly" (ibid. ther." Review of Economic 22 J. 1944).. v. 49. International Currency Experi- Burtle and W. op. Fleming. 1958. 521. chap. as well as cost.. ance-of-payments equilibrium had been sumed to be inoperative if the initial gauged by using a wholesale price index. M. 23 Haberler. p. since under con. exchange rates could hardly ments and calls for the use of a model govern a country's whole general price level.19 and the exchange adjustment undertaken The assumption that constancy of the proved to be insufficient because this money supply would check "foreign-in. 21 Ragnar Nurkse.2' Fur- the possibility of demand. the prices of which reflected of a simplified version of the quantity changes in the world market rather than theory of money and appears to exclude domestic inflationary pressures. 521 ff. since wholesale price indexes are often ger contends that high elasticities will heavily weighted with traded goods. cit. with regard to the overvaluation of push. possibility of commodity arbitrage that The problem of causation is especially would lead to an international equaliza. But both of these types the British pound in 1925. of devaluation necessary to restore bal- tion. the adjustment mechanism is as. 1-28.

2 4. er.. 2.* Belgium Germany Italyt Nether| U. 1964). Now.0 4. 1950-1960 (Per Cent) U.. The purchasing-power parity doctrine tor were in all cases lower than the rise could still find application if produc- This content downloaded from 129. the growth than the rise of productivity in agricul.3 3. Competition among labor groups will now raise wages in the tertiary sector change rates.40 on Mon.. In fact. as a whole as well as for agriculture and ing-power parity theory.. productivity increases in the service sec. tiary sector appear to be generally smaller Finally. PURCHASING-POWER PARITY DOCTRINE 593 Part 11 in connection with the discussion of productivity for the national economy of the absolute interpretation of purchas. Japan lands Agriculture. in present-day industrial econ.1. that in the seven competing goods and an upward pressure major industrial countries examined. and hence service prices will rise.... Tables A 2.. The prices. Trade Prospectsfor Developing Countries (Homewood.194.8 2. while crease in the general price level..4 5.S.9 1. the prices of traded goods will fall marginal rate of transformation and the but service prices will not decline propor- price ratio between the traded commodi. 7 3.5 2.1.5 3.5 4. In a more general model.4 Private GNP l)er man. Should money wages place in the sectors producing traded remain unchanged and productivity im- goods... productivity increases in the ter.9 1.. and this same industry taken separately.9 5.7 4.9 Services . 5. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . accompanies by a smaller rise in provements be translated into lower productivity in the service sector.1 2. where increases in productivity are small- omies...6 3.5 5. indicate the need for adjustment in ex. in intermediate cases. Irwin.. t 1955-1956.252. tion to the growth of productivity so that power parity calculations will incorrectly prices of traded goods remain unchanged.5 1.9t 3. Data derived traded goods will exert a downward pres- for the nineteen-fifties (shown in Table 5) sure on the prices of exports and import- indicate.6..-2. Ill.4 3.. Source: Bela Balassa. the impact poral comparisons. . tionately. for example. 1 Manufacturing only...: Richard D..9 5.2 2. the relative price of the non-traded goods Alternatively.K.6 3. on the general price level of productivity improvements in sectors producing trad- V ed goods can be examined under alterna- Assume that in one of the countries a tive assumptions with regard to changes uniform increase in productivity takes in money wages.0 6. restricting thereby the de- ties will then remain unchanged. we may assume that will rise.. of productivity in the production of ture and manufacturing. 2.. 3. on the prices of services.. model will not be utilized for intertem.. . purchasing.3.3 1..8 * 1947-1960. TABLE 5 ANNUAL RATES OF INCREASE OF PRODUCTIVITY IN INDIVIDUAL SECTORS. since the latter does not money wages (and profits) rise in propor- enter international trade.7 Industry .

. tries do not move in a parallel fashion. 73. pared changes shown by the index of But the purchasing-power parity doc.. At try comparison of changes in the general any rate.. 1962])..... The United States Balance of Payments in 1968 (Washington: Brookings Institute.. W... At the same time. we would expect produc- were identical in every country..S..16 165 103 91 113 Germany . In view of our previous agricultural products too. output per man-hour in manufacturing. . and if tivity improvements in the sectors pro- we also assumed neutral production and ducing traded goods to be positively cor- consumption effects... major industrial countries I have com- justing the rates of exchange.252.. 1953-1961 (Index Numbers for 1961. Correspondingly. and the ratio between cases where prices in individual coun. partly because produc- of technological improvements and wage tivity data for this sector are generally adjustments. and partly because agri- sumed to follow the same course in every cultural prices are affected to a consider- country.197 115 91 126 Source: B.14 143 114 105 109 France .Price Index Man-Hour tured Goods of Manufac- tured Goods (1) (2) (3) (4) United States 124 117 111 105 Belgium .40 on Mon. need for modifications in exchange rate The results are shown in Table 6 and parities. paral.15 152 128 109 117 Italy ... take place and the doctrine will give the To test this hypothesis.. Salant and Associates.. 594 BELA BALASSA tivity increases and wage adjustments ferred to above. index to the index of the prices of traded lel changes in the general price level will goods. "Recent Developments in the Competitiveness of American In- dustry and Prospects for the Future.. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions . changes in the general price to restrict the investigation to the manu- level would be determined in the process facturing sector. I have chosen discussion." Factors AD ecting the United States Balance of Pay- ments (U. assumptions. indicating a positive correlation dual effect of productivity changes re- between the growth of manufacturing This content downloaded from 129. p. 1953 = 100) GNP Deflator Manufac.194. Although traded goods include practical interest. related with the ratio of the general price mittedly restrictive. neither of which can be as- more reliable. given the Figure 2.Wholesale as Percentage turing GNP Prices of of Wholesale Output per Deflator Manufac. 167 115 98 117 United Kingdom 122 127 116 109 Japan . 1963).. Balassa. p. Congress Joint Economic Committee [Washington. Under these. ad.. on the and such instances also have greater other. an intercoun- able extent by governmental policies. index of manufactured products. 38. for seven correct answer: there is no need for ad. trine is asserted to provide guidance in on the one hand.. the countries under considera- price level cannot be used to indicate the tion export chiefly manufactured goods. the GNP deflator and the wholesale price TABLE 6 CHANGES IN PRODUCTIVITY AND PRICES IN SELECTED INDUSTRIAL COUNTRIES.

S. (The correlation coefficient is paid to the behavior of sectoral indexes is . rely on aggregate indexes. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions .K.52 24. however. 125 p-z L0.194.91. its main contribution is a and non-traded goods. statistically significant at the 5 with appropriate disaggregation. price indexes heavily troduction of non-traded goods can weighted with internationally traded enhance the realism of these models and goods will not appropriately indicate the may also offer new theoretical insights. the relative versions of purchasing-power tivity and prices in the sectors of traded parity theory. the reliance on positive one: the emphasis on the need I 130 JAPA N W. The in- mentioned above. PURCHASING-POWER PARITY DOCTRINE 595 productivity and the ratio of the GNP be achieved if.40 on Mon. Factors A fTecting individual commodities.252. It appears like- t1e United States Balance of Paymet~s (Washington.24 per cent level. instead of attempting to deflator to the price index for manufac. BELGIUM x W -j/ . need for modifications in exchange rates In the present instance I have shown either. for amending the familiar models of in- change-rate adjustments appears to be ternational trade by giving explicit con- misplaced.) VI These results provide evidence for the importance of non-monetary factors in While this paper has highlighted some the process of price determination. 24 For a discussion of the effects of price changes This conclusion should not be con- on trade in manufactured goods. 2 general price indexes for deciding on ex. see my "Recent strued as a denial of the sensitiveness of Developments in the Competitiveness of American Industry and Prospects for the Future.50 X (4.48) 110 120 130 140 150 160 170 180 190 200 INDEX OF MANUFACTURING OUTPUT PER MAN FIG. This content downloaded from 129. In the of the inadequacies of the absolute and presence of disparate changes in produc. for reasons sideration to non-traded goods. that more useful results can 1962).105 U SA. Y=76. 120 ILO0 0Z 115 GERMANY LL0 I TALY 0-'S 115 0 W X FRANCE 110 U." U. more attention tured goods. At the same time. ly. pp. 27-64. Con- trade flows to changes in the prices of gress Joint Economic Committee.

those of annual vacations. of transportation involved in foreign the use of exchange rates as conversion travel is disregarded. then. the existence of a system- useful in interpreting disparate move- atic relationship between purchasing- ments in the components of the GNP power parities and exchange rates is indi- deflators and the cost-of-living index as cated in intercountry as well as in inter- well as in projecting future develop- temporal comparisons.596 BELA BALASSA that. low-income countries. Tourism will affect service purchasing-power parities and exchange prices in the individual countries. require the migration 25 Cf. with the degree of An international equalization of service overstatement increasing as income lev- prices will. that. tourism will not ratios will overstate the GNP of high- equalize service prices as long as it is income countries and understate that of restricted to periods of limited length. In general.252. 07 Mar 2016 12:23:54 UTC All use subject to JSTOR Terms and Conditions .25 Further. the conclusions derived with respect to changes over time can be in the model. But even if the cost comes and living standards. my "Patterns of Industrial Growth: Com- of labor in response to intercountry ment." American Economic Review. while in the overvaluation or undervaluation of a above discussion we have assumed that currency. for example. pp. June. differences in living costs.194. and it rates also provides guidance for the in- will tend to reduce international dispari- ternational comparison of national in- ties in these prices. involves international transactions in The observed relationship between services. 394-97. These relation- ments. this assump- over-(under)-valuation. although they tion will have to be modified if account cannot indicate the magnitude of the re- is taken of international tourism that quired revaluation. 1961.40 on Mon. ships can be of some help in judging the Note. however. and changes in the degree of services cannot be traded. This content downloaded from 129. by incorporating non-traded goods els rise.