EIFM LECTURE 4:

EVALUATION AND
APPLICATION OF
PPP
PRESENTED BY DR YANHUI ZHU
28 OCT 2022
OVERVIEW

• In this lecture, we’ll answer the question of why PPP doesn’t work very well empirically
• We’ll also use Balassa-Samuelson model to explain why non-tradable goods tend to be
more expensive in rich countries than in poor countries
• Finally, we’ll understand why it’s better to use PPP exchange rates to measure GDP when
comparing different economies than market exchange rates
RECAP OF PURCHASING POWER PARITY (PPP)

• The absolute version of PPP holds that if one takes a bundle of goods in one country and compares
the price of that bundle with an identical bundle of goods sold in a foreign country, converted by
the exchange rate into a common currency of measurement, then the prices will be equal
• The relative PPP theory argues that the exchange rate will adjust by the amount of the inflation
differential between two economies
• The prediction of PPP is born out in the very long run. However, the consensus estimates suggest
that the speed of convergence to PPP is extremely slow
• The PPP theory often has poor predictive power in the short run; the short-run deviations from PPP
are large and volatile
HOW TO EXPLAIN THE POOR PERFORMANCE OF
PPP?

Transaction costs
Statistical Imperfect
and trade
problems competition
impediments

Differences
Productivity
between capital Non-traded goods
differentials
and goods market
STATISTICAL PROBLEMS

• PPP is based upon the concept of comparing identical baskets of goods in two economies
• An important problem facing researchers is that different countries usually attach
different weights to various categories of goods and services when constructing their
price indices, which means it is difficult to compare like with like when testing for PPP
• Another problem is posed by the differing quality of goods consumed in different
economies
TRANSPORT COSTS AND TRADE IMPEDIMENTS

• PPP relies on arbitragers in international goods market to keep the exchange rate in line
with the level predicted by PPP
• However, transport costs, tariffs and nontariff barriers can create a band around the level
predicted by PPP, within which the deviation would not trigger arbitragers to restore PPP
• Example: If a bundle of goods costs £100 in the UK and $200 in the US, PPP would
suggest an exchange rate of £0.50/$1
• If transaction costs are £20 then exchange rate could lie anywhere between £0.40/$1 and
£0.60/$1 without bringing arbitrage forces into play
IMPERFECT COMPETITION

• PPP is based on the notation that there is sufficient international competition to prevent
major departures of the price of a good in one country exceeding that in another
• However, multinational corporation can often get away from charging different prices in
different countries as there are considerable variations in the degree of competition
internationally
DIFFERENCES BETWEEN CAPITAL AND GOODS MARKET

• PPP is based upon the concept of goods arbitrage and has nothing to say about the role of
capital movements
• However, export and import transactions are small relative to the amount of domestic and
foreign assets at any given time
• For example, foreign exchange transactions in the US are over 25 times greater than the
amount of US exports and imports!
DIFFERENCES BETWEEN CAPITAL AND GOODS MARKET
(CONT’)

• Dornbusch (1976) hypothesised that, in a world where capital markets are highly
integrated and goods markets exhibit slow price adjustment, there can be substantial
prolonged deviations of the exchange rate from PPP
• The idea is that exchange rate adjusts quickly to new information and changes in
economic policy whilst domestic and foreign goods prices are more or less fixed
NON-TRADED GOODS

• PPP is based the assumption that all goods are traded across borders to allow for arbitrage in
international goods market
• However, a significant proportion of the bundle of goods consumed are non-traded
• Non-traded goods are those that cannot be traded internationally at a profit, such as houses and
certain services such as a haircut or restaurant food
• PPP is more likely to hold for traded than non-traded goods. This is because the price of traded
goods will tend to be kept in line by international competition, while the price of non-traded
goods will be determined predominantly by domestic supply and demand considerations
PRODUCTIVITY DIFFERENTIAL

• It is well-documented that when prices of similar baskets of both traded and non-traded goods are
converted into a common currency, the aggregate price indices tend to be higher in rich countries
than in poor countries
• Furthermore, evidence shows that prices of traded goods are nowhere as dissimilar internationally
as those of non-traded goods
• Consequently the overall higher price index in rich countries is mainly due to the fact that non-
traded goods prices are higher in developed than developing countries
• The lower relative price of non-traded goods in poor countries has been explained by Balassa-
Samuelson model
BALASSA-SAMUELSON MODEL – ASSUMPTIONS

Wages are assumed to be

Labour productivity in rich
countries is higher than in
poor countries
The productivity
the same in the tradables
differential occurs
and non-tradables sectors
predominantly in the
within each economy and
tradables rather than the
positively related to
non-tradables sector
productivity

Prices are positively related

to wages and negatively PPP holds for tradables
related to productivity
BALASSA-SAMUELSON MODEL – PREDICTIONS

• Developing country’s low productivity in traded sector leads to the low wage in this sector
• Developing country’s low wage in traded sector leads to low wage in non-traded sector,
even though its productivity in this sector is the same as in developed countries
• Developing country’s low wage in non-traded sector leads to low price in that sector,
relative to that in developed country
• The productivity differential theory can explain why Japanese yen appreciated against US
dollar in the 70s even though Japanese inflation rate was higher than the that of US in that
period
COMPARING DEVELOPING AND DEVELOPED
COUNTRIES
• Imagine you work at the World Bank. You job is to decide which countries need aid or
cheap finance to alleviate poverty and promote growth. How to determine which
countries are the most qualified?
• To compare GDP per capita of different countries you would need to use a method to
estimate exchange rate. What if you use market exchange rate?
• The fact that PPP tends not to hold means that the measures of GDP per capita using
market exchange rate tend to underestimate the income level of developing countries
UNDERESTIMATION OF GDP PER CAPITA – EXAMPLE

• In year 2012 the exchange rate between Chinese yuan and US dollar = 6.3 Yuan/$1
• However, 630 Yuan could buy you 100% more goods in China than the amount of goods that
$100 could buy in US. According to PPP, the exchange rate = 630 yuan/$200 = 3.15 yuan/$1
• Suppose USD GDP per capita = $50,000 and Chinese GDP per capital = 31,500 yuan
• By the market exchange rate, Chinese GDP per capita = 31,500/6.3 = $5,000, which is 10% of
the level in US
• By the PPP exchange rate, Chinese GDP per capita = 31,500/3.15 = $10,000, which is “only”
20% of the level in US – a more accurate reflection of the living standards in the two countries
MEASURES OF INCOME AND SIZE OF ECONOMY

Table 6.3 shows GDP per capita
according to the World Bank
using both the Atlas method and
the PPP method. It is evident
that the estimation method
makes a big difference to the
GDP per capita estimates
Table 6.4 shows the GDP of
different countries using market
exchange rates and PPP
estimates. It is evident that the
size of developing countries is
significantly underestimated
using market rates
THE LARGEST ECONOMY IN THE WORLD?

• https://data.worldbank.org/indicator/NY.GDP.MKTP.CD
• Data using current $ exchange rates GDP using market exchange rates
• Data using PPP exchange rates GDP using PPP exchange rates
• World Bank blog: Tracking GDP in PPP terms shows rapid rise of China and India
READING

• Pilbeam K. (2013) International Finance Chapter 6