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The Purchasing Power Parity
Definition: “At every moment the real parity between two countries is represented by the
quotient between the purchasing power of money in one country and the other. I propose to call
this parity the purchasing power parity.”
Gustav Cassel

The Purchasing-Power Parity Doctrine:
A Reappraisal
Absolute interpretation of the doctrine:
PPP calculated as a ratio of consumer goods prices tends to approximate the equilibrium
exchange rates.

Relative interpretation of the doctrine:
Changes in relative prices indicate the necessary adjustments in exchange rates.

together with the FX rate. determine completely the pattern of prices and of productions. and Exchange Rates Samuelson’s Statement: “the theory of competitive advantage does not guarantee a country against balance-of-payments difficulties” Because: Comp Adv Theory -> We would never be exporting a good i while exporting a good j if our competitive advantage is in good j rather than in good i However. or that our total BoP is at equilibrium. R. .Equilibrium of Prices. this does not say that our current balance will balance our. Wages. The price of a good at any place equals the lowest cost of production anywhere translated into commensurate currency units (transport and tariffs not included). Money wages abroad. W and w.

than in slow growing.Effect: Definition “Countries with high productivity growth also experience high wage growth. The accompanying increase in inflation makes inflation rates higher in more rapidly growing economies. .” The Balassa-Samuelson effect proposes that a rise in wages in the tradable goods sector of an emerging economy will result in a rise in wages in the non-tradable (service) sector of the economy. which leads to higher real exchange rates.Bela Balassa and Paul Samuelson (1963) . established economies.

dollar compared to the German mark raises the question of what meaning can be attached to an international comparison of exchange rates and purchasing-power parities.) about overvaluation of the U. .The Purchasing-Power Parity Doctrine: Problem Description The argument of Houthakker (1962.S.

Samuelson continues the problem with:
1) American and European cost-of-living were sometimes computed with different good
weightings; such index numbers should not be used together in:

2) Heavy transport costs and impediments DO exist, making price ratios not uniform,

The Purchasing-Power Parity Doctrine:
1. two-country model with international trade
2. non-traded good (services)
3. one limiting factor: labor
4. constant marginal rates of transformation
5. one country has an advantage in the production of traded goods

The Purchasing-Power Parity Doctrine:
By assuming that international productivity differences are greater in the production of traded
goods than in the production of non traded goods, the currency of the country with higher
productivity levels will appear to be overvalued in terms of purchasing-power parity.
If per capita incomes are taken as representative of levels of productivity, the ratio will take a
following form:

The ratio is an increasing function of income levels.

. Gilbert and Kravis provide evidence of the relatively high cost of services in countries with higher income levels.the final bill of goods consumed in individual countries. raising thereby the cost of services in high-income countries. The international productivity differences in the service sector are considerably smaller than in the production of the traded goods.The Purchasing-Power Parity Doctrine: Introduction to Empirical Testing Index number problem: the results will depend on the choice of weights .

The Purchasing-Power Parity Doctrine: Empirical Testing Hypothesis: higher level of service prices at higher income levels lead to systematic differences between PPP and equilibrium exchange rates. .

Productivity increases in the service sector appears to be generally smaller than the rise of productivity in agriculture and manufacturing.The Purchasing-Power Parity Doctrine: Empirical Testing Assumption: small rise in productivity in the service sector and uniform increase in productivity in the traded goods sector will rise the relative price of the non-traded goods. .

The Purchasing-Power Parity Doctrine: Empirical Testing PPP doctrine will hold if productivity increases and wage adjustments are identical in every country (parallel changes in the general price level). Technological improvements and wage adjustments don’t follow the same course in every country. . There will be no need for adjusting the rates of exchange. an intercountry comparison of changes in the general price level cannot be used to indicate the need for modifications in exchange rate parties. Correspondingly.

The Purchasing-Power Parity Doctrine: Empirical Testing Hypothesis: productivity improvements in the sectors producing traded goods are positively correlated with the ratio of the general price index to the index of the prices of traded goods. .

. Price indexes heavily weighted with internationally traded goods will not appropriately indicate the need for modifications in exchange rates. the reliance on the general price indexes for deciding on exchange-rate adjustments appears to be misplaced.Results In the presence of changes in productivity and prices in the sectors of traded and non-traded goods.

. PPP and exchange rate relationship can be used to provide guidance for the international comparison of national incomes and living standards. with the degree of overstatement increasing as income levels rise.Conclusion The emphasis on the need for the familiar models of international trade adjusted with consideration of non-traded goods. There is a relationship between PPP and exchange rates which can be used in judging the overvaluation or undervaluation of a currency. The use of the exchange rates as conversion ratios will overstate the GNP of high-income countries and understate that of low-income countries.

one percent increase in productivity differential caused about 1. . Real exchange rate is defined in external terms as the nominal exchange rate adjusted for the price level differences between countries.Balassa-Samuelson Effect in Transition Economies: The Case of Slovenia It is argued that on average one percent increase in labor productivity in industry and services appreciated external real exchange rate by almost 1.5 percent in the period from 1993:1 to 2001:2. At the same time.7 percent increase in CPI.

Price of non-tradeable goods will be lower in less-developed countries than in industrial countries. . The general price level will be lower in less-developed countries.Balassa-Samuelson Effect in Transition Economies: Transition Economies Productivity gap is larger for tradable goods than for non-tradable goods.

Transition Economies: Model .

Transition Economies: Model .

Transition Economies: Model .

and Uzbekistan. The longest series runs from 1990 to 1998. Belarus.Transition Economies: Data 19 transition economies to construct price index: Armenia. while the shortest covers the period from 1995 to 1998. Kazakhstan. Kyrgyzstan. The whole sample includes 122 observations. Romania. Slovenia. Hungary. Poland. Russia. Azerbaijan. Croatia. Czech Republic. Lithuania. Latvia. Ukraine. Bulgaria. Romania and Russia. . Slovak Republic. Estonia. The criterion for the period of observation was the year after which the relative price of tradable goods in terms of non-tradable goods started to consistently decline except in case of Belarus.

there will be offsetting movements in the relative price of tradable goods in terms of non-tradable goods.Transition Economies: Results Structural reforms in transition economies contributed to the real appreciation trend. . Productivity differential used to measure the Balassa-Samuelson effect had a pronounced effect on appreciation of the real exchange rate in transition economies. If the productivity in the two sectors within the country grows at different rates.

The portions of columns correspond to actual contributions that each variable had to the level of the real exchange rate in each year of the transition process. The sum of all portions of a column and country-specific constants add up to the fitted value for the real exchange rate level in the respective year.The Case of Slovenia Stacked columns represent the level of real exchange rate in each year. .

The Case of Slovenia .

The Case of Slovenia As the effect of demand variables represented by the share of non-tradable consumption in total private consumption and government consumption has remained relatively unaltered. . The main determinants of the level of real exchange rate in Slovenia were structural changes and productivity differential.

For that reason. the productivity differential believed to cause the real exchange rate appreciation via Balassa-Samuelson effect has started to affect the level of real exchange rate relatively more than the extent of structural reforms which has diminished in recent years. Thereafter labor productivity in industry has been increasing faster than in services. From 1996 onwards.The Case of Slovenia The structural changes caused the increase of labor productivity in both sectors before 1996. the productivity differential between labor productivity in industry and services has started to effect the real exchange rate substantially. .

The Case of Slovenia .

It’s size varies around 1.5% per year based on 1% increase of the productivity differential between labor productivity in industry and services. .Slovenia: Conclusion The existence of the Balassa-Samuelson effect has been confirmed.

Considers productivity differential of each sector and the weight of the tradables sector in Romania in relation to the Euro Area. .The Balassa-Samuelson Effect in Romania This paper aims to provide estimates of the Balassa-Samuelson effect in Romania– the extent to which differences in productivity growth between tradables and non-tradables industries explain the observed differences in inflation between Romania and the Euro Area.

.Romania: Model The international Balassa-Samuelson explains the extent to which the inflation differential between the two countries is explained by the productivity differential between traded and non- traded industries.

. Nominal exchange rates of domestic currency against the euro (quarterly averages).Romania: Data The source of data is Eurostat and The National Bank of Romania databases. Employment (quarterly averages) in tradable and non-tradable industries. The economies and periods covered are Romania (2002:Q1-2006Q4) and Euro Area (2002:Q1- 2006:Q4). Description of variables: Quarterly observations of value added from the production side GDP estimates(decomposed into tradables and non-tradables) CPI rates of inflation.

wages in this sector have the tendency to rise but.Romania: Empirical Evidence The Balassa-Samuelson model assumes that productivity is higher in the tradable sector. the increase in salaries spreads across the whole economy . since labor is mobile. As a consequence.

Romania: Empirical Evidence .

Labor mobility determined the wages in the non-tradable sector to rise as much as wages in the tradable sector. although productivity gains are smaller.Romania: Empirical Evidence The wage growth was similar across the two sectors which is consistent with the theory. .

Romania: Empirical Evidence .

06 percentage points (2002Q1:2006Q4).Romania: Results Balassa-Samuelson effect in Romania explains on average only 0.569 percentage points of the observed inflation differential -8. .

are responsible for the observed differences in inflation rates.Romania: Conclusion The estimates are lower that those obtained in previous studies because we considered the effect of the productivity differential on the inflation differential and not on domestic inflation. The Balassa-Samuelson effect does not explain much of the observed inflation differential. Thus factors. . other than productivity differences.

. EU member states. the inflation differential. and other countries of Central and Eastern Europe.using both monthly and annual data .The Case of Croatia This paper wishes to analyze the importance of the B-S effect for Croatia. which are a figure to the size of the long-run inflation. and the real appreciation which was driven by the B-S effect .investigate the basic assumptions of the B-s hypothesis . or are hoping to become new.

The reason for this undervaluation in terms of PPP can be usually traced back to the traditional Balassa-Samuelson argument: the less developed country is usually less productive in producing tradable goods. .Croatia: Theoretical Background (Model) “It is a well-understood fact that purchasing power parity (PPP) in its absolute version does not hold true for transitional and developing countries because these countries’ currencies are undervalued in terms of PPP” Real Exchange Rate: A real exchange rate higher than 1 = undervalued.

Transform it using logarithms: where const is a constant term containing log(γ ) and log(δ ). δ and γ denote the share of labour in the open and closed sectors -> represents the growth rate of the relative price of non-tradable goods -> is the sectoral difference of growth rates of total factor productivity. The model continues… This relationship can be worked out in a formal way by using a two-sector neo-classical framework with perfect capital mobility and with the interest rate assumed exogenous. where circumflexes (^) stand for growth rates and small letters indicate variables taken in natural logarithms. Change the initial equation on the basis of avg labour productivity we get: where Y and L denote output and labour and Y L is average labour productivity (ALP). .

public administration and other communal services) (4) a measure of (3) completed with agriculture.Sector Breakdown Open Sector Breakdown: (1) manufacturing (2) industry (3) industry and agriculture (4) industry. and hotels and restaurants and finally (5) agriculture. . transport and telecommunications. industry. (1) and (2) augmented with agriculture if not used in the open sector (3) market-based sectors and non-market based sectors (education. transport and telecommunications. and hotels and restaurants. Alternative Measures for Closed Sector Breakdown: (1) the remaining market-based sectors (2) the remaining market-based sectors plus real estates. health. This yields a total of 18 combinations between open and closed sectors.

Max lag length set to 6. Critical Values defined by MacKinnon The bounds testing approach uses the error correction form of the ARDL model . respectively. leads and lags. Croatia: Estimation Techniques Dynamic Ordinary Least Squares (DOLS): where k1 and k2 denote.

Real wages are linked to productivity in the open sector 2. Nominal wages tend to equalize across sectors 3.Croatia: Basic Assumptions 1. Dual productivity is linked to the relative price of market-based non-tradable goods 4. PPP holds for the open sector .

generally speaking. . productivity and real wages broadly grew hand in hand. otherwise.Croatia: Empirical Evidence (Yearly) Croatia: Wages rose more slowly than productivity from 2000 to 2002.

unlike in Romania where the ratio decreased implying that nominal wages grew faster in the closed sector than in the open sector (amplification of the B-S effect).Croatia: Empirical Evidence (Yearly) Croatia . except for jump-like changes can be observed.Wage Equalization: Pretty stable. .

The sectoral wage ratio is difference stationary. The tradable price-based real exchange rate is difference stationary. . 3. with the estimated long-term coefficient being equal to 1. 2. Productivity in the open sector is cointegrated with real wages in the open sector. with the estimated long-term coefficient being equal to 1. Dual productivity is cointegrated with the relative price of market-based nontradable goods. 4.Croatia: Empirical Evidence (Monthly) More rigorous assumptions 1.

with the estimated long- term coefficient being equal to 1 Results for Croatia indicate a cointegration which can be detected unambiguously only when the bounds testing approach (ARDL) is used. .Croatia: Empirical Evidence (Monthly) Passed: 1. The estimated long-run coefficient is slightly higher than 1 and increases somewhat for the period from 1998 to 2004. Productivity in the open sector is cointegrated with real wages in the open sector.

In sum. including Croatia. either have a unit root or are trend stationary. i. 1996 to 2004. The Augmented Dickey Fuller (ADF).e. The sectoral wage ratio is defined as the ratio of nominal gross wages in industry to those in the whole economy. while the Kwiatowski-Phillips-Schmidt-Shin (KPSS) test mostly rejects stationarity for the whole sample and for a shorter period. . the Phillips-Perron (PP) and the Elliott-Rothenberg-Stock (ERS) point optimal unit root tests are unable to reject the presence of a unit root. The sectoral wage ratio is difference stationary. Note also that the wage ratios based on both gross and net monthly wages exhibit trend stationarity for the subperiod. all series.Croatia: Empirical Evidence (Monthly) Failed: 2. implying the first and/or second moments to be unstable over time.

Croatia: Empirical Evidence (Monthly) Semi-Passed: 3. Dual productivity is cointegrated with the relative price of market-based nontradable goods. we can observe that productivity and relative prices based on service prices (SERVGOODS or SERVPPI). . the OLS estimates of the first different data are systematically insignificant or have the wrong sign. with the estimated long-term coefficient being equal to 1. Finally. CPI-to-PPI ratio can be viewed as (services and goods)/goods while the two other variables are constructed as services/goods Croatia: No cointegration is found for Croatia. The CPI-to-PPI ratio (CPIPPI) rescues Croatia as there seems to be a positive relationship for Croatia (as opposed to the no-cointegration finding for SERVGOODS and SERVPPI). In the results. .

. Croatia: From the results. The tradable price-based real exchange rate is difference stationary.Croatia: Empirical Evidence (Monthly) Failed: 4. it can be seen that the PPI-based real exchange rate is clearly not difference stationary in levels.

. the results indicate that relative PPP is rejected for the real exchange rate of the open sector. * The B-S effect could then provide an explanation for some of the changes in the difference between the (CPI-based) overall real exchange rate and the real exchange rate of the open sector. which implies that the B-S effect will not be able to explain the entirety of real exchange rate movements. what is the influence of the B-S effect on overall inflation? Also. Croatia: Conclusion? They concludes that the results indicate that the B-S effect could POSSIBLY work well in Croatia… However.

ideally. should be 1. PROD is the average labour productivity in the tradable (T) and non-tradable (NT) sectors. which connects the relative price of non-tradables to productivity.Croatia: B-S effect on Inflation Rates where (1 − α) is the share of non-tradables in the consumer basket β1 conceptually corresponds to the estimated coefficient from Tables 4a and 4b. . and which.

However. This is mainly because such figures do not take account of productivity increases in services. Nevertheless. Croatia: B-S effect on Inflation Rates Table 6a Table 8 Croatia appears to be less influenced by the choice of sectoral classification. industrial production-based figures indicate a positive effect. the effect rises to about 0.8 percentage point in Croatia for the period of 1996–2002. Results indicate that the B-S effect may be negative for Croatia in the period of 1992 – 2002 when using data based on national accounts. .

using data obtained from national accounts seems more appropriate for measuring the B-S effect: This would imply an equilibrium appreciation in Croatia.Croatia: Equilibrium Real Appreciation When adjusting the figures in Table 8 with a foreign benchmark (avg of prior 3 studies: 1. .2% for 1992–2003 and 1. However.0% for 1996–2003) we find that for Croatia: the direction of a change in the equilibrium exchange rate hinges on whether or not national accounts or industrial production-based data.

-> The Balassa-Samuelson effect is found to play only a slightly than limited role for overall inflation and real exchange rate determination. .Croatia: Final Conclusion Analysis of the basic assumptions of the B-S effect reveals: that the pass-through from productivity gains in the open sector to the relative price of non-tradable goods is not proportionate Because: (a) real wages are not proportionately linked to productivity in the open sector (b) the wage equalization process across sectors is far from perfect (c) the relative price of non-tradables rises quicker or slower than productivity gains even when taking account for the imperfect functioning of the two other assumptions. Other external factors are deemed more important than the B-S effect.

in part. by productivity. Comparison to Developed G7 Countries The results of the empirical application of the Samuelson-Balassa hypothesis for G-7 countries suggest that relative prices of non-tradable to tradable goods are explained. . Increases in tradable sector relative to non-tradable sector productivity increase the relative prices of non-tradables. Faster growth in productivity in the traded sector. relative to productivity growth in the nontraded sector. increases the relative price in the nontraded good.

the CIS. J. . Jazbec. Dumitrescu B. Samuleson. (2005) “Balassa-Samuelson Meets South Eastern Europe. B. Dedu.References 1. (2003) “The Balassa-Samuelson Effect in an Imperfectly Competitive Economy: Empirical Evidence for G7 Countries” . V. (1964) “Theoretical Notes on Trade Problems” 3. Coto-Martinez. J. (1964) “The Purchasing-Power Parity Doctrine: A Reappraisal” 2. (2010) “The Balassa-Samuelson Effect in Romania” 4. Reboredo. Egert. . B. B. Balassa. P. (2002) “Balassa-Samuelson Effect in Transition Economies: The Case of Slovenia” 5. and Turkey: The Close Encounter of the Third Kind?” 6.

Thank you for your attention! .

Back up slides .

Introduction to Empirical Testing .

Romania: Model Aggregate price level is decomposed into a traded and non-traded component both domestically and abroad: The real exchange rate is defined: Then based on these relations it is obtained: .

Romania: Model Law of one price holds in the tradable sector: Next we determine the relation between the change in relative prices and the productivity differential between traded and non-traded sector Small open economy and a Cobb-Douglas production function: .

Romania: Model The profit functions for both economies: Necessary and sufficient conditions for profit maximization: .

Romania: Model Thus. . we have: The relative price of non-tradable versus tradable will rise if the productivity in the tradable sector is higher.

Romania: Empirical Evidence .

Romania: Empirical Evidence .