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Purchasing Power Parity: Law of One Price and PPP
Purchasing Power Parity: Law of One Price and PPP
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tions, empirical studies usually examine the validity and the test for the validity of PPP can be translated to
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research interest. One implication of the bias is that account for a large fraction of government spending.
purchasing power parity
results from developed countries may overstate the Thus government spending tends to have a positive
empirical support for PPP. A related issue is whether impact on a countrys real exchange rate.
developed and developing countries have similar real Other economic factors that affect real exchange
exchange rate behavior. Cheung and Lai (2000a) rates include net foreign asset position, distribution
conduct a large-scale analysis and find substantial sector, and market structure. Since the turn of the
cross-country heterogeneity in the persistence of 21st century, the net foreign asset position has been
deviations from parity, and it is more likely, rather introduced to a real exchange rate equation via
than less likely, to find parity reversion for developing portfolio-balance channels (Lane and Milesi-Ferretti
countries than developed countries. 2002). The role of net foreign asset position is related
A perplexing and well-known empirical regularity to the effect of current/trade account balances artic-
is that real exchange rates display both a high level of ulated in the 1980s and 1990s. The effect of net
persistence and an intense amount of short-term foreign asset position is verified in a number of em-
volatility (Rogoff 1996). If one attributes large short- pirical studies. It is noted, however, that the con-
term volatility to some dominating nominal shocks, struction of data on national net foreign assets in-
then the observed persistence is too high to be ex- volves approximations and these data are all in U.S.
plained by price stickiness. This phenomenon is la- dollars.
beled a PPP puzzle. Several attempts have been The prices faced by consumers are affected by
made to explain the puzzle. One study shows that, distribution costs. The productivity and efficiency of
when sampling uncertainty is taken into consider- the distribution sector will have an impact on the
ation, the estimated persistence parameter gives only price structure and, thus, on real exchange rate be-
a very imprecise measure of the true persistence havior. Intuitively, the distribution activity occurs
(Cheung and Lai 2000b). Thus the observed persis- within a locale and is likely to be a nontradable
tence puzzle may not be a well-defined puzzle. Sub- service. In the Balassa-Samuelson effect parlance,
sequent studies also point out that the estimated level improved distribution sector productivity should
of persistence can be reduced to a nonpuzzling level be associated with a depreciation of the real exchange
when, say, nonlinearity adjustment mechanisms are rate. Nonetheless, the extant empirical evidence
considered. points in a different directiona result that may be
Economic Factors So far the discussion has driven by tradable components in the distribution
mainly drawn from studies based on the time-series sector (MacDonald and Ricci 2005). One caveat is
(a la intertemporal) properties of exchange rate and the paucity of data on productivities of distribution
price data. What economic factors affect the behavior sectors.
of the real exchange rate, which is a measure of PPP The implication of market structure for the ad-
deviations? justment of relative prices to exchange rate move-
The Balassa-Samuelson effect is perhaps the most ments was recognized in the 1980s. A model with,
discussed economic force shaping real exchange rate say, a markup pricing strategy that is a function of the
behavior. The hypothesis is related to the observation degree of monopolistic power offers an easy illus-
that, when measured in the same unit, price levels in tration of the market structure effect on real exchange
high-income countries are higher than those in low- rate behavior. Indeed, the market structure has im-
income countries. The price differential is due to the plications for both the persistence and volatility of
difference in productivities in the tradables and real exchange rates. As always, the availability of
nontradables sectors. The Balassa-Samuelson effect is proper data is a challenge for the empirical valuation
a supply-side factor. A demand-side factor is gov- of the market structure effect. Since the turn of the
ernment spending. It is perceived that nontradables 21st century, some positive evidence of market
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structure effects has been reported using sectoral data FURTHER READING
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Rogoff and Gene Grossman. Amsterdam: North Hol- Exchange Rates: An Empirical Investigation. Journal of
purchasing power parity
land, 164788. An often-cited survey article with a lot of Political Economy 105: 86279. Appealing to the effect
references. of transaction costs, the study uses nonlinear models to
Goldberg, Pinelopi K., and Frank Verboven. 2005. Mar- describe real exchange rate behavior.
ket Integration and Convergence to the Law of One Niehans, Jurg. 1984. International Monetary Economics.
Price: Evidence from the European Car Market. Jour- Baltimore, MD: Johns Hopkins University Press. Pre-
nal of International Economics 65: 4973. Presents evi- sents a model that gives the PPP condition with the
dence in favor of LOP. assumption of one product satisfies the LOP condition.
Lane, Philip, and Gian Maria Milesi-Ferretti. 2002. Ex- Officer, Lawrence H. 1982. Purchasing Power Parity and
ternal Wealth, the Trade Balance, and the Real Exchange Exchange Rates: Theory, Evidence, and Relevance.
Rate. European Economic Review 46: 104971. Con- Greenwich, CT: JIA Press. An extensive review of the
nects real exchange rate behavior to net foreign asset early literature on PPP.
positions. Rogoff, Kenneth. 1996. The Purchasing Power Parity
MacDonald, Ronald, and Luca Antonio Ricci. 2005. The Puzzle. Journal of Economic Literature 34: 64768. An
Real Exchange Rate and the Balassa Samuelson Effect: often-cited survey article with a lot of references.
The Role of the Distribution Sector. Pacic Economic Sarno, Lucio, and Mark P. Taylor. 2002. Purchasing
Review 10: 2948. Develops a theoretical model and Power Parity and the Real Exchange Rate. IMF Staff
provides empirical evidence of the link between the Papers 49: 65105. Covers some recent developments in
distribution sector and real exchange rate dynamics. the empirical PPP literature.
Michael, Panos, A. Robert Nobay, and David A. Peel. 1997.
YIN-WONG CHEUNG
Transaction Costs and Nonlinear Adjustment in Real
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