Purchasing power parity PPP is built on the notion of arbitrage across goods markets and the Law of

1
Focus on PPP

• Purchasing power parity (PPP) is built on the
  notion of arbitrage across goods markets and the
  Law of One Price.
• The Law of One Price is the principle that in a
  PCM setting, homogeneous goods will sell for the
  same price in two markets, taking into account
  the exchange rate.

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• PPP conditions do not imply anything about
  causal linkages between prices and exchange rates
  or vice versa.
• Both prices and exchange rates are jointly
  determined by other variables in the economy.
• PPP is an equilibrium condition that must be
  satisfied when the economy is at its long-term
  equilibrium.

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PPP in practice

• In reality, seemingly homogeneous goods may
  differ in a number of important respects which
  undermine tests of the Law of One Price.
• One test of the Law of One Price is the Big Mac
  index, which has been published annually in The
  Economist since 1986.
• It was devised as a light-hearted guide to
  whether currencies are at their correct
  level, based on PPP.

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Is there McParity?

• Cross-country comparison of Big Mac prices
• prices of Big Macs in 41 countries (published in
  the Economist (1986- ))
• advantages homogeneous good, quality
  control over inputs
• disadvantages imperfect competition (strategic
  pricing), are inputs the same? (nontradables?),
  government regulations may affect product pricing

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Empirical Evidence on Prices and Exchange Rates
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Researchers have investigated whether current
deviations for Big Mac Parity help forecast
future changes in exchange rates.Answer Yes,
sort of. The Economist claims that the Big Mac
method predicted the depreciation in the Euro
following its introduction in 1999.
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Persistent deviations from PPP
A manager may really only care about the duration
of deviations from PPPdo they last several
months? Years? Forever? Key question Is
there mean reversion in the real exchange rate
does it tend to go back to q1? Lets look at a
graph of the real exchange rate, which also
clearly indicates the deviation from PPP
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Mean reversion RER tends to return to q1

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Empirical Evidence on Prices and Exchange Rates

• A parity condition can be viewed as a 45 line
  passing through the origin with the Left Hand
  Side (LHS) and Right Hand Side (RHS) variables
  plotted on the x and y axes.
• Thus, parity conditions can be tested by running
  the simple linear regression
• LHSt ? ? RHSt ?t
• Parity holds when the data cannot reject a null
  hypothesis where ? 0, ? 1, and the error
  terms have classical properties.

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Regression test of relative PPP

• If relative PPP true, s/peso pUS pmex
• This is expressed in changes
• Run regression of the form
• s/peso,t a b( pUS,t pmex,t) et

Regression test of relative PPP means testing the
null hypothesis a0, b1. Remember we may
reject or fail to reject the null hypothesis. We
are not allowed to say we accept it!
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Test for US-Germany Quarterly data, 1973-93.

• Estimates, with standard errors in parentheses
• 0.005 (se0.010) b 0.50 (se1.05) R2
  0.003
• Null hypothesis PPP true a0, b1.
• Construct t-statistic if absolute value of t lt
  2, cannot reject null hypothesis.
• t (estimate-true value under null)/se
• Test a0 t (.005 0)/0.01 0.50 cannot
  reject
• Test b1 t (0.50-1)/1.05 -0.476 cannot
  reject
• Conclusion These data do not reject relative
  PPP for US-Germany over this period. Butwe will
  see that the data cant reject the alternative
  hypothesis that a0, b0 either!

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Alternative hypothesis exchange rate changes
are completely unrelated to inflation
differentials a0, b0 Construct the
t-statistics a0 t (.005 0)/0.01 0.50
cannot reject b0 t (0.50-0)/1.05 0.476
cannot reject The 95 confidence interval for b
is the estimate plus/minus two standard
errors 0.50 2(1.05) lt b lt 0.50 2(1.05) -1.60
lt b lt 2.60 These data are very uninformative
about b.
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Quarterly Deviations from Relative PPPCPI
Germany and the United States, 1973-1999
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More Empirical Evidence on PPP

• During a hyperinflation period, even the
  demanding regression-style test tends to support
  PPP. This means fails to reject PPP, while not
  failing to reject a0, b0.
• But, this is mainly due to the fact that monetary
  influences on prices completely dominate real
  influences on product prices.

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More Empirical Evidence on PPP

• Long-run data indicated that the real exchange
  rate did not evolve as a random walk, but
  demonstrated a clear tendency to revert back to
  its central value. This long-run tendency is
  called mean reversion.
• Definition A variable follows a random walk if
  upward and downward movements are always equally
  likely if the future path of the variable is
  completely unpredictable from past information.

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Empirical Evidence onPrices and Exchange Rates

• Note that the real exchange rate itself may not
  be constant.
• It may change on a permanent basis if a real
  shock affected one country but not its trading
  partners.
• The Balassa-Samuelson hypothesis states that
  countries that have experienced high productivity
  gains, higher real income growth and higher real
  incomes should have appreciating real exchange
  rates.

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Empirical Evidence onPrices and Exchange Rates

• Empirical tests confirm that ...
• PPP is a poor descriptor of exchange rate
  behavior in the short run, where the rates are
  quite volatile and domestic prices are somewhat
  sticky.
• But in longer-run analysis, it appears that PPP
  offers a reasonably good guide.

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Policy Matters - Private Enterprises

• If managers can identify the deviations from
  parity that are growing larger or likely to
  persist, then profit-maximizing decisions can be
  made.
• Knowing that deviations from parity occur,
  managers may adopt strategies that reduce their
  exposure to the risks of such deviations.

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Policy Matters - Public Policymakers

• Deviations from PPP, by definition, measure
  changes in a countrys international
  competitiveness, and reveal whether a currency is
  overvalued or undervalued relative to a simple
  standard.
• However, there are limitations on the usefulness
  of PPP in policy decisions, as real macroeconomic
  disturbances call for a change in the real
  exchange rate.

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The covered interest parity diagram
r-r
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International Financial and Exchange Rate
Adjustments
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The interdependence of the parity conditions
(Uncovered) interest parity
Fisher-open
(Expected) PPP
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Interest parity in the presence of transaction
costs
Incentive to borrow in dollars and invest in
pounds
Unprofitable arbitrage
0.005
r-r
-0.005
Unprofitable arbitrage
Incentive to borrow in pounds and invest in
dollars
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Round-trip covered interest arbitrage
borrowing ---- investment
borrowing ---- investment
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One-way covered interest arbitrage
Future pounds to spot dollars
Spot dollars to future pounds