EC563: International Finance

Purchasing Power Parity

28
th
January
Absolute PPP
The Law of One Price (LOP)
Departures from LOP: transport costs,
trade barriers; imperfect information
The iceberg model
PPP in aggregate price levels:
S = P/P*
Why is absolute PPP unlikely to hold?
Measurement issues
Traded vs non-traded goods
Relative PPP
%S = %P - %P*

Does not require that absolute PPP hold
Overcomes the problem of transactions
costs by (implicitly) assuming they are
proportionate to price
Earliest application: post-WWI return to
Gold Standard
PPP and the real exchange rate
Real exchange rate: Q = SP*/P
Absolute PPP implies a real exchange
rate of unity
Relative PPP implies a constant real
exchange rate
PPP precludes variation in the real
exchange rate
A theory of exchange rate
determination or of inflation?
S = P/P*
P = SP*
%P = %S + %P%

A useful but very basic model of inflation in an
SOE (price-taker)
Slightly more complex model (Scandinavian)
incorporates trade/non-traded distinction

Summary of evidence on PPP
Doesnt hold in the short run
Short run real exchange rate volatilty
dominated by movements in nominal exchange
rate
Real exchange rate volatility greater for floating
than for fixed rate regimes
Some evidence that PPP holds in the long run
Half-life of real exchange rate shocks estimated
at 3-5 years

Applications of PPP
Determining appropriate exchange rate
parities
Determining the degree of exchange
rate misalignment
International comparison of living
standards
Most economists instinctively believe in some variant of PPP as an
anchor for long-run real exchange rates: Rogoff (1996)
Evolution of empirical testing:
short run
Size and volatility of LOP deviations for
seemingly highly traded goods
International vs intra-national price
differentials: evidence of a border effect
Evidence of pricing to market (i.e. price
discrimination) by monopolistic firms
From the short to the long run
The failure of short run PPP can be attributed in part
to stickiness in nominal prices: as financial and monetary
shocks buffet the nominal exchange rate, the real
exchange rate also changes in the short run
If this were the whole story however, one would expect
substantial convergence to PPP over one to two years,
as wages and prices adjust to a shock.

Rogoff (2006)
What is the PPP puzzle?
How to reconcile the enormous short-term
volatilty of real exchange rates with the very
slow rate at which shocks appear to damp out
Most explanations for real exchange rate
volatility focus on the stickiness of prices and
wages
But, is it credible that such nominal rigidities can
explain real disturbances that last for many
years?
Tests of long run convergence
Testing (and failing to reject) the random walk
hypothesis; testing for a unit root
Resolving the power problem* by using long-
horizon data sets
The problem of mixing different fixed and
floating exchange rate systems
Testing with cross-country data sets
Modelling non-linear convergence
* Until the late 1980s, testing was ususally carried out on relatively
short time series. The tests therefore did not have enough power to
Reject the null hypothesis of a random walk even if false.
The Balassa-Samuelson
hypothesis
Rich countries have higher overall price levels than poor
countries, measured in a common currency
Why is this?
Rich countries have relatively higher productivity in the
traded goods sector
Wage levels are equalised across traded and non-traded
sectors in both sets of economies
Rich countries will exhibit higher prices for non-traded
goods and services because wage levels there will be
driven by the relatively higher productivity traded sector

Balassa-Samuelson algebra*
Pn = Wn/Zn and Pt = Wt/Zt (Poor country)
P*n = W*n/Z*n; P*t = W*t/Z*t (Rich country)
Wn = Wt and W*n = W*t
Z*t > Zt but Z*n = Zn
S = Pt/P*t
Pn/Pt = ; P*n/P*t = *
(Wn/Zn)/(Wt/Zt) =
Zt/Zn =
Z*t/Z*n = *
But, since Zn = Z*n and Z*t > Zt, * >
Pn/Pt = ; SP*n/SP*t = *
But, since Pt = SP*t and * >
Then Pn* > Pn
* Note: additional algebraic material presented on acetate
Implications of Balassa-
Samuelson
Real exchange rate of poor countries based on
aggregate price indices will tend to be overstated
Purchasing power of a dollar will tend to be
systematically higher in poor than in rich countries
GDP per capita estimates for poor countries at market
exchange rates will tend to underestimate living
standards
Applying BS to catch-up growth of traded sector
productivity: such economies will experience faster
inflation and a changing (equilibrium) real exchange
rate
Inflation differentials in early years of EMU
References
Copeland, Ch 2
Pilbeam, Ch 6
Kenneth Rogoff (1996): The Purchasing
Power Parity Puzzle, JEL Vol.34 No.2
Taylor & Taylor (2004): The Purchasing
Power Parity Debate, JEP Vol.18 No.4