Evidence on PPP

1. Evidence on PPP Antu Panini Murshid

2. Today’s 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. For developing countries the evidence in favor of relative PPP often appears stronger, given their higher inflation experience Relative PPP: Developing Countries, Very Long-Run 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 differentiation—there 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 goods—nontradables—transport 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 conditions—this is called price discrimination

32. Example: Nissan’s Sunderland Plant • In the early 1990s a Nissan automobile built in Sunderland, England, could be purchased in England for £16,215. The same car—manufactured in Sunderland—could 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: Nissan’s 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 $36,000/9=$4,000

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 $36,000/4=$9,000

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