LECTURE 5: Purchasing Power Parity

– IRP - ER

Primary Motivation: How realistic is the assumption

P=?
  Secondary motivation: How integrated are global goods
markets?
ERFAN OVEE NOMAAN
 • Definition(s) of PPP (Absolute vs. Relative PPP)

• Does PPP hold in practice?

• Barriers to international goods market arbitrage
• Four observed patterns of deviation from PPP
• Arbitrage enforces the Law Of One Price
in some sectors

but not
in others:

• Appendix 1: PPP within the Monetary Approach to the B of P

LEC 5 – PPP, INFLATION, EXCHANGE RATE
 
PPP: ALTERNATIVE DEFINTIONS
 Absolute PPP :
P ≡ price of a basket of goods in domestic currency
esp. from the World Bank’s International Comparison Program.

• RER = 1, where real exchange rate RER ≡ E

• P = E P*
• E=
 
=

LEC 5 – PPP, INFLATION, EXCHANGE RATE

 PPP: ALTERNATIVE DEFINTIONS (continued)

Relative PPP
CPI ≡ is a price index, expressed relative to an arbitrary base year
e.g., “CPI2000 ≡ 100.0” (from national agencies).

Define real exchange rate Q ≡ E .

• Q is constant (at ),  
or E=
• CPI (E)(CPI*) .
• Depreciation = π - π*, where π and π* are
domestic & foreign inflation rates.

LEC 5 – PPP, INFLATION, EXCHANGE RATE

Does PPP hold in practice?

No.

Q varies a lot.

LEC 5 – PPP, INFLATION, EXCHANGE RATE

 Barriers to International Integration
of Goods Markets

• Transportation costs, which depend on:

• geography
• technology

• Tariffs & non-tariff trade barriers

• Currencies
• Other border frictions
LEC 5 – PPP, INFLATION, EXCHANGE RATE
 Long-distance transport costs
fell during the 19th century.

Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING 1869-1950 by

Saif I. Shah Mohammed and Jeffrey G. Williamson
NBER Working Paper 9531 (http://www.nber.org/papers/w9531)
ITF-220 PROF.J.FRANKEL
By 1914, low
transport costs,
UK-led free trade,
& the Pax
Brittanica allowed
arbitrage between

the US & UK
in wheat.

ITF-220 PROF.J.FRANKEL
 Arbitrage enforces the Law Of One Price
in some sectors, but not in others
For homogeneous mineral & agricultural
commodities, the Law of One Price
◦ holds, if there are no trade barriers (gold),
◦ fails, if there are trade barriers (sugar).

For goods & services not traded internationally,

there can be no arbitrage (haircuts).

Other sectors fall in between:

◦ Manufactured goods.
◦ Big Mac hamburgers.
LEC 5 – PPP, INFLATION, EXCHANGE RATE
The Law of One Price holds relatively well
for a standardized metal such as gold.

{ Note: India has tariffs &

quotas on gold imports.

LEC 5 – PPP, INFLATION, EXCHANGE RATE

High trade
barriers in
agricultural
products
are still
common,
preventing
price
arbitrage.

LEC 5 – PPP, INFLATION, EXCHANGE RATE

 Prices of nontraded
services vary widely.
Notice that they are
lower in poorer (low-
wage) countries
than rich.

LEC 5 – PPP, INFLATION, EXCHANGE RATE

 Jan.22, 2014

Why is the price

of Big Macs

so high in Norway?

Big Macs are partly

traded (ingredients) & higher in Brazil
partly nontraded
(cooking & retail).
Their price varies widely than in Japan?
across countries.

Low in India
& S.Africa?

LEC 5 – PPP, INFLATION, EXCHANGE RATE

 Non-Traded Goods
Even if arbitrage quickly equalized prices for traded goods,
it would not do so for goods that are not traded internationally.
If the price of Non-Traded Goods rises more rapidly in Japan than in
the US, then the yen will come to appear overvalued in real terms,
i.e., relative to PPP.
Balassa-Samuelson effect: higher income per capita =>
higher relative price of non-traded goods => real appreciation.
◦ Usual mechanism: the higher productivity occurs in Traded Goods sector
= > ( PTG /PNTG ) ↓ .
◦ But PTG = E PTG *, tied to world markets
either way,
{ E ↓ (under a float)
or PNTG ↑ => CPI ↑ } => (E P*/CPI)↓ :
real appreciation.
LEC 5 – PPP, INFLATION, EXCHANGE RATE
Balassa-Samuelson relationship:
Absolute price levels are higher in rich countries
(real exchange rates are lower).

1/Q

LEC 5 – PPP, INFLATION, EXCHANGE RATE

 Bottom line conclusion from PPP
for the rest of the course
 
For most goods & services, prices are “sticky”
◦ i.e., we can take their prices as exogenous in the SR.
◦ Exceptions:
◦ mostly agricultural & mineral products
◦ Especially in very small open economies.

After a few years pass (Medium Run),

we must realize that prices adjust,
◦ closing about ¼ gap per year.

In the Long Run, prices may adjust fully,

◦ returning us to a LR PPP equilibrium,
◦ although even in the LR there can be changes in ,
◦ e.g., from exogenous changes in terms of trade
◦ or from Balassa-Samuelson effect.
LEC 5 – PPP, INFLATION, EXCHANGE RATE
 Appendix 1: PPP within the Monetary Approach of
Balance of Payment
Effect of a devaluation

E ↑ => P ↑ => (M/P) ↓ =>

(M/P) < L => “Excess Demand for Money”
=> residents cut back spending on goods (or assets)
=> BP ↑ the “real balance effect.”

=> Reserve /saving rising over time

+ Nonsterilization M rising over time

}
=> BP is self-correcting.

ITF-220 PROF.J.FRANKEL
Source: FREIGHT RATES AND PRODUCTIVITYGAINS IN BRITISH TRAMP SHIPPING 1869-1950 by
Saif I. Shah Mohammed and Jeffrey G. Williamson
NBER Working Paper 9531 (http://www.nber.org/papers/w9531)

LEC 5 – PPP, INFLATION, EXCHANGE RATE

Appendix 3:
The Big Mac
Index in 2000. The price tends
to be higher in
rich countries
(e.g., Europe & Japan,
compared to China),

and in countries
with overvalued
currencies
(e.g., Argentina
in 2000).

LEC 5 – PPP, INFLATION, EXCHANGE RATE

 Three years later,
Big Macs were still
expensive in Europe and
cheap in China;

but now (2003), they were

cheaper still in Argentina.
Why?
Devaluation.

Source: The Economist, January 2003.

LEC 5 – PPP, INFLATION, EXCHANGE RATE