Evidence on PPP

1
Evidence on PPP

• Antu Panini Murshid

2
Todays Agenda

• Evidence on PPP
• Explaining departures from PPP
• A general model of long-run exchage rates

3
Does the Law of One Price Hold?

• There is little evidence to suggest that it holds
  in the short-run
• The evidence that it holds in the long-run is
  stronger but still weak

4
So Why Waste Time Studying PPP?

• There are two reasons
• First while PPP often does not seem to hold,
  significant departures from PPP are probably not
  sustainable
• Second, PPP is a key building block of more
  general exchange rate models that are more
  realistic than the monetary approach and that
  perform better

5
Examining the Evidence

• We will now consider the evidence on
• The law of one price
• Absolute PPP
• Relative PPP
• A case study on a high-inflation country

6
Hamburger Standard

• The Big Mac Index has been published annually in
  the Economist Magazine since 1986
• It measures the variation in the price of a Big
  Mac across countries
• It was devised as a quirky test of whether
  long-run exchange rates were in fact at their
  correct level

7
Why look at Big Macs?

• The most important reason for looking at Big Macs
  is that the quality is almost identical across
  countries (homogenous good)
• Also Big Macs are sold in over 40 countries

8
Bad News for McParity
9
What Happens in the Long-Run?

• There are significant differences in the price of
  Big Macs
• In Malaysia the price of a Big Mac is about half
  of what it is in the US
• In Switzerland it is 50 higher than the US price
• Subsequent Big Mac surveys have shown no
  universal tendency for a narrowing of the 1986
  price differentials
• So violations of the LOP can be persistent

10
700 Years of Evidence

• Froot, Kim and Rogoff (1995) examine annual
  commodity price data from England and Holland
  over a span of seven centuries
• Data price of barley, butter, cheese, eggs,
  oats, peas, silver and wheat and pound/shilling
  exchange rate dating back to 1273
• Evidence of persistent deviations from the law of
  one price over this entire period

11
How Do We Test Absolute PPP?

• Given our McParity results, is there any hope for
  absolute PPP?
• Yes, since the Big Mac may be in some sense
  special
• To test absolute PPP it is therefore important to
  start with a broad reference basket of tradable
  commodities after having made careful adjustments
  for differences in quality

12
Evidence on Absolute PPP

• Frankel has shown that PPP is supported in the
  data when annual observations over 100 years are
  included in the sample
• However Bahmani-Oskoee rejected evidence of
  long-run PPP in a sample of industrial countries
• In general most studies have concluded that PPP
  is way off the mark!

13
Relative PPP

• The evidence on relative PPP is a little better
• Relative PPP seems to have held quite well during
  the Bretton Woods era but broke down in the 1970s
• May be the exchange rate regime has something to
  do with it, although Froot et. al. (1995) would
  disagree

14
Relative PPP US-Canada Annual Data
15
Relative PPP US-Canada 5-Year Averages
16
Relative PPP US-Canada

• What can we infer from the above two charts?
• There is no evidence of a one-to-one
  correspondence between inflation differentials
  and the rate of depreciation of the exchange rate
• The exchange rate is more volatile than inflation
  differentials
• In the short-run there is no relationship.
  However over longer periods there is some
  evidence that the exchange rate tracked inflation
  differentials between the two countries
• From 1992 this relationship breaks down

17
Relative PPP US-Germany Annual Data
18
Relative PPP US-Germany 5-Year Averages
19
Relative PPP US-Germany

• The exchange rate is highly volatile (in the
  post-Bretton Woods period)
• There is some evidence of a near one-to-one
  correspondence between inflation differentials
  and exchange rate movements prior to the 1970s.
  Since the 1970s, there is a weak correlation
  between these two variables, often punctuated by
  long periods of divergence

20
Relative PPP Industrialized Countries, Very
Long-Run 1950-2000
average rate of depreciation of the currency
outlier
average inflation differential
21
Relative PPP Developing Countries, Very Long-Run

• For developing countries the evidence in favor of
  relative PPP often appears stronger, given their
  higher inflation experience

average rate of depreciation of the currency
outlier
average inflation differential
22
High Inflation Countries

• As the previous slide shows there is stronger
  evidence of relative PPP when we focus on high
  inflation countries
• It turns out that while there can be persistent
  departures from PPP, these departures cannot be
  too pronounced
• PPP will eventually assert itself. Below we
  examine some case studies

23
Collapse of the Mexican Peso in 1982

• From 1977, prior to 1982 the Mexican peso traded
  for about 22.57 pesos per dollar (exchange rate
  was fixed)
• However, over this time, Mexican inflation was
  always higher than US inflation
• In January 1982 the exchange rate had crept up to
  26.4 pesos.
• On February 5th President Lopez announces that
  the central bank will defend the peso like a
  dog
• On February 19th the peg was abandoned

24
Collapse of the Mexican Peso in 1982
25
Summarizing Evidence

• Little evidence that absolute PPP holds
• Not surprising since the law of one price does
  not seem to hold lack of McParity, case in point
• Relative PPP does not hold in the short run and
  there is weak evidence that it holds in the
  long-run in general
• Over the very long-run possibly, especially for
  high inflation countries relative PPP seems to
  hold

26
Why the Lack of McParity?

• Big Macs are not directly tradable
• Government regulations differ
• Product differentiationthere are probably fewer
  substitutes for Big Macs in some countries
• Differences in wages

27
Why Might We Expect Deviations From PPP in
General?

• Transport costs and restrictions on trade
• Imperfect competition
• Inflation data reported in countries are based on
  different commodity baskets

28
Trade Barriers and Nontradables

• Trade barriers and transport costs make it
  expensive to move goods between countries. This
  weakens the link between exchange rates and goods
  prices
• For some goodsnontradablestransport costs are
  so large that they cannot be traded
  internationally
• The existence of nontradables allows systematic
  deviations from PPP

29
Imperfect Competition and Government Regulations

• The law of one price states that higher prices in
  one country will generate arbitrage
  opportunities. These arbitrage opportunities
  will spark a flow of goods and services from the
  low-price country to the high-price country until
  the price differentials are eliminated
• Implicit in this argument is the assumption that
  markets are competitive and that governments do
  not regulate prices

30
Government Regulations Price Controls

• If the government places a price ceiling for
  instance, there will be persistent departures
  from PPP

31
Imperfect Competition

• When markets are imperfectly competitive prices
  might not equalize across two markets
• A firm may charge two separate prices in two
  markets based on demand conditionsthis is called
  price discrimination

32
Example Nissans Sunderland Plant

• In the early 1990s a Nissan automobile built in
  Sunderland, England, could be purchased in
  England for 16,215. The same carmanufactured
  in Sunderlandcould be purchased in Japan for
  13,375, despite the cost of shipping the car
  10,600 miles
• In this case Nissan is able to price discriminate
  because it is so much more costly for the
  individual to ship a car from England to Japan
• Thus transport costs and imperfectly competitive
  market structures together further weaken the
  linkages between national price levels and
  exchange rates

33
Example Nissans Sunderland Plant
UK Market
Japan Market
price of cars in
price of cars in
16,215
13,375
MC
DJp
DUK
quantity
quantity
MRUK
MRJp
34
International Differences in the Reference Basket
of Commodities

• There are international differences in what
  consumers consume
• Norwegians for instance may have a strong
  preference for reindeer meat
• Japanese have a preference for sushi
• While the average Indian has a preference for
  lentils
• Consequently a high weight will be put on
  reindeer meat in Norway, in Japan a high weight
  will be placed on fish and in India a high weight
  will be placed on lentils. Thus the reference
  commodity basket to measure purchasing power will
  vary across countries

35
Implications for Absolute PPP

• The implications of this will be that the price
  of a typical basket of commodities purchased by
  consumers in the US will not be directly
  comparable to the price of a typical basket of
  commodities consumed in India, Japan, or Norway
• A fair test of absolute PPP therefore should not
  be based on the price indexes constructed in each
  nation

36
Implications for Relative PPP

• However if all US prices increase by 10 and the
  dollar depreciates against foreign currencies by
  10, relative PPP will be satisfied, even though
  each reference basket in each country is so
  different
• Thus we might expect relative PPP to fair better.
  However, the problem is that prices of all goods
  usually do not go up in unison. Often there are
  changes in relative prices

37
Price Level Differences and Incomes

• A striking empirical regularity is that price
  levels, when expressed in a single currency, tend
  to be higher in richer countries than in poorer
  countries
• A dollar goes further in India than in the US
• International differences in the prices of
  nontraded goods appears to be a major
  contributing factor

38
Price Levels and Real Incomes, 1992
39
Balassa-Samuelson Effect

• So why are prices of nontradables so much lower
  in poor countries
• One explanation was offered by Bela Balassa and
  Paul Samuelson that is not inconsistent with the
  law of one price
• Two Key Assumptions
• Labor forces of poor countries are less
  productive than the labor forces of rich
  countries in the tradable sectors
• Labor forces are equally productive in the
  nontradables sector

40
How Reasonable Are the Assumptions?

• The assumptions are actually not bad, since the
  tradable goods often entail highly capital
  intensive production methods that lead to sharp
  differences in productivity across rich and poor
  countries
• By contrast nontradables are often services, like
  haircuts, that do not need heavy capital
  investment and the latest technologies
• It is probably fair to say that a hairdresser in
  India is just as productive as a hardresser in
  the US

41
Implications of Productivity Differences in
Tradables

• The assumption that there exists productivity
  differences in the tradable goods sector has
  strong implications for the price of labor in the
  nontrable sectors and consequently for prices of
  nontradable goods and services

42
An Example India

• Suppose India makes a traded good (cars) as well
  as a nontraded good (haircuts)
• The price of cars is given by the world market at
  36,000 per car (so by assumption the law of one
  price holds)

43
continued

• It takes 9 workers 1 year to make one car
• Suppose all the revenue from the sold cars goes
  to the workers
• This means that each year a worker receives
  36,000/94,000

44
continued

• How much money should hairdressers make?
• If labor markets are competitive then
  hairdressers should also make 4,000
• Suppose that in one year one hairdresser can do
  100 haircuts, that means each haircut should cost
  40

45
An Example USA

• Suppose the US also makes cars and provides
  haircuts
• The price of a car is 36,000 (this is because we
  assume that the law of one price holds for
  tradable goods)

46
continued

• US workers in the car industry are more
  productive than Indian workers. Specifically
  suppose that it takes 4 workers 1 year to make
  one car
• Again we suppose all the revenue from the sold
  cars goes to the workers
• This means that each year a worker receives
  36,000/49,000

47
continued

• If labor markets are competitive then
  hairdressers should also make 9000
• By assumption hairdressers in the US are as
  productive as hairdressers in India, hence in one
  year one hairdresser can do 100 haircuts, that
  means each haircut should cost 90

48
continued

• Consequently a reference commodity basket
  consisting of one car and 100 haircuts will cost
  40,000 in India, but 45,000 in the US because
  the price of nontradables is higher
• The price of nontradables is higher because
  workers in the nontradable sector in the US are
  paid more

49
Balassa-Samuelson Effect Summary

• Prices of traded goods are equalized by goods
  arbitrage
• If rich countries tradable sectors are more
  productive, then wages will be higher in these
  countries
• Higher wages in turn generate higher prices for
  nontradable goods
• This implies that productivity growth in the
  tradable sector will lead to a higher price level
  even if the price of tradable goods do not change

50
Explaining Departures in PPP

• There is mixed evidence on PPP. However it is
  fair to say that it does not hold generally
• We can identify the reasons why PPP fails
• Price rises in nontradable goods, government
  regulations, or market imperfections could be
  important factors
• Below we will examine two cases where PPP has
  failed to hold

51
Hong Kongs Surprisingly High Inflation

• Since 1983 the Hong Kong dollar has been fixed at
  HK7.37 per US dollar
• However over that period Hong Kongs inflation
  has averaged 6.38 while US inflation has
  averaged 3.27
• Clearly relative PPP has not held

52
continued
53
continued

• What can explain the different inflationary
  outcomes in the two countries?
• Unlike many countries Hong Kong has few
  restrictions on trade or regulations on price
• In recent years however, there has been high
  inflation in the price of services and
  nontradables and steep increases in rent
• By comparison there has been relatively moderate
  inflation in tradables

54
The Steady Rise of the Yen

• Between 1950 and 1971 the Japanese yen was fixed
  at 360 per dollar, since then the yen has risen
  sharply in value. The current spot exchange rate
  is 120 per dollar. A 300 appreciation against
  the dollar
• PPP would imply that this was because US
  inflation was three times as high as Japans
  inflation. In fact between 1972 and 2000 the
  inflation rate in Japan averaged 4.1, the
  corresponding figure for the US was 5.2

55
continued

• So what explains the amazing appreciation of the
  yen?
• The answer is suggested by the Balassa-Samuelson
  effect
• Richard Marston found that productivity growth in
  Japans tradable goods far outpaced productivity
  growth in nontradables
• Between 1973-1983 productivity growth in
  tradables exceeded nontradables by 73.2, the
  corresponding figure for the US was 13.2

56
continued

• Productivity growth in tradables has raised wages
  throughout the economy
• This has produced significant inflation in the
  nontradables
• Thus the relative price of nontraded goods in
  terms of traded goods has risen over time in
  Japan, and it has done so more quickly than in
  the US

57
A More General Model of Long-Run Exchange Rates

• PPP clearly fails to hold on many occasions, but
  often we can explain why this is the case
• In light of this it is appropriate to amend our
  long-run theory of exchange rates that allows for
  departures in PPP for reasons that we have
  examined

58
Real Exchange Rate

• As a first step to developing our extended theory
  of long-run exchange rates we will reintroduce
  the real exchange rate
• Recall that real exchange rate is defined as
  ?ePf/P
• In a nutshell the real exchange rate is the
  dollar price of a basket of foreign goods divided
  by the dollar price of a basket of US goods

59
Real Exchange Rate Appreciation/Depreciation

• PPP ? ?1. However PPP does not always hold
• What does it mean if ? gt 1 or ? lt 1?
• If ? gt 1 then a basket of foreign goods is more
  expensive than a basket of US goods
• If ? lt 1 then a basket of foreign goods is
  cheaper than a basket of US goods
• In general when ? ? foreign goods become more
  expensive relative to US goodsthis is called a
  real depreciation of the dollar
• When ? ? foreign goods become less expensive
  relative to US goodsthis is called a real
  appreciation of the dollar

60
Allowing For Departures in PPP

• We can rearrange our expression for ? and obtain
  e?P/Pf
• According to the monetary approach to the
  exchange rate ?1 hence eP/Pf however now we
  want to allow departures from PPP
• The above expression implies that
• For a given real exchange rate, changes in money
  demand or supply affect the exchange rate as in
  the monetary approach
• Changes in the real exchange rate also affect the
  long-run nominal exchange rate

61
Determinants of the Long-Run Exchange Rate

• A shift in relative money supply
• A shift in relative money growth rates
• Any non-monetary changes that affect the real
  exchange rate
• This could be for instance an increase in
  productivity in the tradables sector as was the
  case for Japan

62
High Inflation Countries and PPP

• Earlier we saw that relative PPP seems to hold
  quite well for high inflation countries. Based
  on what we have learnt we can now speculate why
  this is the case
• High inflation is the outcome of monetary changes
  and not structural shifts such as increase in
  productivity
• Thus in high inflation countries monetary factors
  are more prominent