Transcript the price of non-tradable goods and services is significantly lower

Part Ⅱ
Exchange-Rate
Determination: Theory,
Evidence and Policy
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Chapter 6
Purchasing Power Parity
and Floating Exchangerate Experience
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6.1 Introduction
In this chapter , we look at one of the earliest
and simplest models of exchange rate
determination, known as PPP.
 An understanding of PPP is essential to the
study of international finance.
 the theory has been advocated as a
satisfactory model.
 The theory provide a point of reference for the
long-run exchange rate.
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Main contents of the chapter:
1.Look at the PPP theory—6.2-6.4.
2.Examine how well-suited it is to
explaining actual exchange-rate
behavior—6.5-6.7.
3.Discuss some of the possible
explanations for its failure—6.8,6.9.
4.The importance of PPP estimates—6.10.
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6.2 PPP Theory and the Law
of One Price



PPP is generally attributed to Gustav
Cassell’s writings in the 1920s.
The basic concept: arbitrage forces will
lead to the equalization of goods prices
internationally once the price of goods
are measured in the same currency.
As such, the theory represents an
application of the ‘law of one price’.
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The law of one price:
1.This law simply states that in the
presence of a competitive market
structure and the absence of transport
costs and other barriers to trade,
identical products which are sold in
different markets will sell at the same
price when expressed in terms of a
common currency.

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2.the law of one price is based upon the
idea of perfect goods arbitrage.
UK:£15000(P) S=£0.5/$(PPP) US:$30000(P*)
If S=£0.6/$, then:
$30000=£30000*0.6
= £18000>£15000
UK car cheaper,
buy UK car, sell in US,
buy £ and sell $, £↑ & $↓ till S= £0.5/$.
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UK:£15000(P) S=£0.5/$(PPP) US:$30000(P*)
If S=£0.4/$, then:
$30000=£30000*0.4
=£12000<£15000
US car cheaper,
buy US car, sell in UK,
buy $ and sell £, $↑ & £↓ till S= £0.5/$.
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6.3 Absolute and Relative PPP
PPP comes in two forms:
Absolute PPP: based on a strict
interpretation of the law of one price;
Relative PPP: ‘weaker’ variation.

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1.Absolute PPP.
Absolute 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.
It is expressed as: S=P/P*
(6.1)
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2.Relative PPP.
The absolute PPP is unlikely to hold
precisely (transport costs, imperfect
information, tariffs and other forms of
protectionism)
a weaker form of
PPP can be expected to hold even in the
presence of such distortion.
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Relative PPP argues that the exchange rate
will adjust by the same amount of the
inflation differential between two
economies.
It is expressed as:
%∆S=%∆P-%∆P*
(6.2)
That is, according to the relative version,
the percentage variations in the
exchange rate equal the percentage
variations in the ratio of the price level of
the two countries
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Note:
The percentage variations in this ratio are
proximately equal to the difference
between the percentage variations in the
two price levels, or inflation differential.

13
Example:
£120(P0), $200(P0*), S0=£0.5/$(actual)
10%
6%
≠£0.6/$(PPP)
£132(P1), $212(P1*), S1=£0.52/$
≠£0.622/$(PPP)
(S1-S0)/S0=(S1-0.5)/0.5=10%-6%=4%
S1=£0.52/$
If the relative PPP holds, it does not
mean that the absolute PPP necessarily
holds.
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6.4 A Generalized Version of
PPP

One of the major problem with PPP is
that it is suggested to hold for all types
of goods. However, PPP is more likely to
hold for traded than non-traded goods.
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Traded goods: are goods that are
susceptible to the rigours of
international competition, be they
exports or import-competing industries
such as most manufactured goods.
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.
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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 predominately by
domestic supply and demand
considerations.
A more generalized version of PPP
that provides some useful insights
makes a distinction between traded and
non-traded goods.
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Consider the importance of the
tradables/ non-tradables distinction for
PPP when aggregate price indices made
up of both tradables and non-tradables
are considered.
First, assume PPP hold for tradables:
PT=SPT*
(6.3)
The aggregate domestic price index:
(6.4)
PI  PN  (1   ) PT

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The aggregate foreign price index:
PI *  PN * (1   ) PT *
(6.5)
Dividing equation (6.4) by (6.5):
PN  (1   ) PT
PI

PI * PN * (1   ) PT *
(6.6)
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Divide the numerator by PT and the
denominator by SPT*:
  ( PN / PT )  (1   ) 
PI
 S

PI *
  ( PN * / PT *)  (1   ) 
(6.7)
Rearranged to give the solution for S:
PI   ( PN * / PT *)  (1   ) 
S


PI *   ( PN / PT )  (1   ) 
(6.8)
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From equation (6.8):
1.it is an important modification to our simple
PPP equation because PPP no longer
necessarily holds in terms of PI and PI* due to
the multiplicative term on the right-hand side;
2.it suggests that the relative price of nontradables relative to tradables will influence
the exchange rate. That is:
If PN↑→S↓: PN↑→PT↓ to keep PI↕→S↓ to
maintain PPP for tradables;
If PT↑→S↑.
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Implications:
 The tradable/non-tradable distinction
serves as a warning when testing for PPP.
Testing for PPP using price indices based
on tradable goods prices is likely to lead
to better results than when using
aggregate price indices made up of both
types of goods.
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
Exchange-rate movements induced by
changes in relative prices between
tradable and non-tradable goods
represent real exchange-rate changes.
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6.5 Measurement Problems in
Testing for PPP
1.To decide whether or not the theory is
supposed to be applicable to both traded and
non-traded goods, or applicable to only one
of these categories.
First: seems more readily applicable to traded
goods;
However: the distinction is fuzzy and there are
mechanisms linking both categories.
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The argument is important for the
empirical testing for PPP theory:
If applicable only to tradables: the price
index made up of only traded goods—
wholesale or manufacturing price
indices;
If applicable to both goods: a more
general price index should be
employed—consumer price index.
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2.An overall problem facing researchers
whichever price index is used is that
PPP is only expected to hold for similar
baskets of goods with similar weights.
3.The base period for the test should
ideally be one where PPP held
approximately.
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4.there are divergences of view over the
time-span during which PPP can be
expected to assert itself:
Strong version: on a monthly basis;
Progressively weaker version: on a
quarterly or six-monthly or yearly-andbeyond basis.
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6.6 Empirical Evidence on PPP
1.Graphical evidence on PPP.

Figure 6.1(a)-(g) illustrate that the
exchange rate has diverged
considerably from that suggested by
PPP.
$/£ & DM/$ & JPY/$ & JPY/DM: PPP does
not do at all well in tracking the actual
rate.
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LIT/DM & FF/DM & £/DM: although there
are deviations from PPP, that PPP does
a reasonable work.
This is not that surprising since transport
costs and trade barriers between France,
Italy and Germany are small.
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
It is noticeable that although the
exchange rate is frequently far from PPP,
it does have a tendency to go back to
the PPP rate over the long run------PPP
may be a useful guide for the
determination of the long-run exchange
rate.
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2.Econometric evidence on PPP.
Testing for PPP by use of regression
analysis.
In log form:
Absolute PPP: ln S t  a1  a2 (ln Pt  ln Pt *)  ut
Relative PPP:  ln S t  a1  a2 ( ln Pt   ln Pt *)  ut
In both cases, for PPP to hold the
regression estimates would yield a1=0
and a2=1.
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The regression estimates provide
additional support for the graphical
analysis.
The overall evidence on the PPP
hypothesis is not very supportive.
In sum, there is much more to
exchange-rate determination than PPP.
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6.7 Summary of the Empirical
Evidence on PPP


PPP performs better for countries that
are geographically close to one another
and where trade linkages are high;
There have been both substantial and
prolonged deviations from PPP which
have frequently been reversed over a
number of years;
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

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Exchange rates have been much more
volatile than the corresponding national
price levels;
Empirically, PPP holds better in the long
run than the short run;
PPP is the dominant force in
determining their exchange rates in
countries having very high inflation;
Overall, PPP holds for traded goods than
non-traded goods.
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

An influential paper by Rogoff(1996)
shows that deviations from PPP are not
speedily corrected, while Sarno and
Taylor(2002) dispute the evidence
reported by Rogoff.
PPP is much less likely to hold if one
uses CPI, than if wholesale price
indices(WPI) are used; significantly
better is the use of a tradables price
index(TPI).
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6.8 Explaining the Poor
Performance of PPP Theory
1.Statistical problems:


Different countries usually attach different
weightings to various categories of goods and
services when constructing their price indices;
Differing consumption baskets are not of such
significance, however, there is a problem
posed by the differing quality of goods
consumed.
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2.Transport costs and trade impediments.
To take the transport costs and trade
impediments into account, the results
of PPP theory will be changed.
Nonetheless, since transport costs and
trade barriers do not change
dramatically over time they are not
sufficient explanations for the failure of
the relative version of PPP.
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3.Imperfect competition.
One of notions underlying PPP is that there is
sufficient international competition to prevent
major departures of the price of a good in one
country from its price in another. However, it is
clear that there are considerable variations in
the degree of competition internationally.
Because the conditions necessary for successful
price discrimination are for the most part more
likely to hold between rather than within
countries.
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4.Differences between capital and goods
markets.
PPP has nothing to say about the role of
capital movements. However, 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.
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5.Productivity differentials.
Because the higher labor productivity in the
traded sector in developed countries
compared to developing countries makes
non-tradables goods prices are higher in
developed than developing countries, the
aggregate price indices tend to be higher in
rich countries than in poor countries when
prices of similar baskets of both traded and
non-traded goods are converted into a
common currency.
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6.9 The Balassa-Samuelson
Model
Balassa and Samuelson argue that labor
productivity in rich countries is higher
than in poor countries. Furthermore,
this productivity differential occurs
predominately in the tradables rather
than the non-tradables sectors.
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1.Analyze process:
 Assume:
1.PN=WN/QN, PT=WT/QT
PN*=WN*/QN*, PT*=WT*/QT*
2.WN=WT; WN*=WT*
3.QT*> QT, QN*= QN
4.S= PT/ PT*
(6.9)
(6.10)
(6.11)
(6.12)
(6.13)
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
*
N
*
N
Then: PN
WN Q
WT


 *
*
PN
QN W
WT
PT  QT
S  P  QT
 * * 
S
*
*
PT  QT
PT  QT
*
T


Thus: PN  S  P
PPP does not work for non-traded goods.
*
N
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2.Reason: low wages in the developing
country due to low productivity in its
traded sector also lead to a relatively low
price for its non-traded goods,even
though its productivity in this sector is
the same as in developed countries.
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3.Significances:
The Balassa-Samuelson model is helpful in
explaining:
 Why it is that rich countries tend to have
overall high price indices and poor countries
low price indices;
 Why the ratio of non-traded to traded price
tends to be higher in developed economies
than developing countries;
 Why there are divergences from PPP in
terms of aggregate price indices between
developed countries.
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4.Limitation:
 It is only a partial explanation;
 It can not explain the failure of PPP to
hold for traded goods.
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6.10 Per capita income levels,
the relative sizes of economies
and the importance of PPP
estimates


The World Bank keeps a very keen eye
on the per capita income levels of
developing countries.
The fact that PPP tends not to hold is of
considerable importance in this respect.
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
It is well-documented that, in particular,
the price of non-tradable goods and
services is significantly lower in

developing countries than in developed
countries, simply because PPP is not
holding.
In particular, the exchange rates of
developing countries tend to be
noticeably undervalued in terms of
purchasing power for goods and
services.
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The implications for calculations of GDP
per capita.
United states: $35000; China: ￥8600.
If market exchange rate: $1=￥8.6.
Chinese GDP per capita(M)=$1000.
If PPP exchange rate: $1=￥1.72(=8.6/5).
Chinese GDP per capita(PPP)=$5000.

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
The GDP per capita based on PPP is
therefore a more reliable guide to
relative living standards in the two
countries than using the market
exchange rate which does not reflect
PPP.
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

The previous example calculation is by
no means far from reality.
GDP per capita according to the World
Bank using both the Atlas method and
the PPP method shows that GDP per
capita of developing countries are
seriously undervalued using market
exchange rate.
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
Not only do PPP adjustments make a
significant difference to GDP per capita
estimates, they also make a big
difference to the importance of the
relative size of different economies.
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6.11 Conclusions

The experience with floating rates has
shown that there can be substantial and
prolonged deviations of exchange rates
from PPP.
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

There are many explanations for these
deviations from PPP. Among the
strongest candidates is that the theory
has no role for the international capital
movements.
The fact that PPP does not hold very
well in the short to medium term does
not mean that it has no role to play in
exchange –rate determination.
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Further reading:
 程伟，《基于双重法的经济规模的国际
比较》，《当代财经》，2008/05。
 魏佳，《巴萨效应在中国适用性的实证
分析》，《特区经济》，2008/05.
 耿琳，《国际货币汇率是否符合购买力
平价理论——一种计量经济学的分析视
角》，《财经界》，2008/01.
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