Lecture 9: SOURCES OF DEVIATIONS FROM PURCHASING POWER PARITY (PPP)

1. BarrierstoInternationalIntegration Transportation costs Tariffs & non-tariff trade barriers Border frictions Currencies. Non-Traded Goods The relative price of NTGs The Balassa-Samuelson Effect Deviations from the Balassa-Samuelson line. Lecture 9: SOURCES OF DEVIATIONS FROM PURCHASING POWER PARITY (PPP)

2. NBER WP 9531 Real Freight Rates for Jute from Calcutta to UK (1884=1.00) Long distance transport costs fell sharply during the late 19th century. API-120 - Prof. J. Frankel

3. By 1914, low transport costs, free trade in the UK, & the PaxBrittanica, allowed arbitrage between the US & UK in wheat. API-120 - Prof. J. Frankel

4. Agricultural products still feature high trade barriers, preventing price arbitrage. API-120 - Prof. J. Frankel

5. CROSS-BORDER TRADE BARRIERS: KEY FINDINGS (after controlling for trade policy & geographic variables) API-120 - Prof. J. Frankel

6. Engel & Rogers “How Wide is the Border?” AER(1996) Crossing the border, e.g., from Vancouver to Seattle, adds more friction into price arbitrage than traveling the length of the continent from Atlantic to Pacific. API-120 - Prof. J. Frankel

7. Rose (2000), the mostinfluentialempirical paper in international monetary economics in the last 15 years: Applying the gravity model of bilateral trade to a large sample of countries reveals not only that a reduction in bilateral exchange rate variability encourages trade, even after controlling for common colonial history, etc., but that joining a currency union results in an estimated tripling of trade among the partners. (exp(1.2)=3).

8. NonTraded Goods & Services Why is the cost of living so high in Tokyo and so low in Mumbai? Why was Buenos Aires in 2001more expensive than Paris or Frankfurt ?... API-120 - Prof. J. Frankel

9. In 2004, Tokyo was still very expensive. But Buenos Aires had fallen far below Paris or Frankfurt. Why? The peso collapsed in 2002. API-120 - Prof. J. Frankel

10. So the real exchange rate varies with each country’s relative price of NTGs. API-120 - Prof. J. Frankel

11. One important application of TG/NTGs, esp.for long-run trends. The Balassa-Samuelson effect: (PNTG/PTG),and therefore 1/Q, rises with countries’ real incomes. The usual B-S reason: Productivity growth takes place in the TG sector, reducing prices there relative to wages and PNTG. • The statistical relationship between income per capita • and the absolute real exchange rate is well documented. • Some cross-section studies: • the original Balassa article (1964) = .04 + .37 (.09) (.04) • Rogoff (1996): • recent studies of RMB undervaluation (see below). • It takes more work to verify that productivity growth operates via the relative price of NonTraded Goods. • E.g., DeGregorio, Giovannini & Wolf (1994). API-120 - Prof. J. Frankel

12. The original Belassa article showed 1960 levels. API-120 - Prof. J. Frankel

13. Distinguishng TGs from NTGs is difficult in practice.Estimates of tradability calculated forabout 200 products, as the worldwide trade/output ratio, relative to average tradability of all products If more than 2% ofthesectoristraded, it must be tradable. Tradable goods Non-Tradable Goods Data: 20 OECD countries, 1985-1999, from UNIDO (2000) & US.Commerce Dept. (2002). Source: Robert E. Lipsey & Birgitta Swedenborg, 2010,Review of World Economics. http://www.nber.org/papers/w13239

14. If morethan2% of the sector is traded, it must be tradable. De Gregorio, Giovannini & Wolf (1994), “InternationalEvidence on Tradables and NontradablesInflation” In almost all countries, the ratio of NTG prices to TG prices rises over time (“Baumol’s cost disease”). Japan had the strongest trend during the post-war period. API-120 - Prof. J. Frankel

15. The countries with the strongest productivity growth tend to show the strongest upward trend in the relative prices of NTGs (1970-1985) . API-120 - Prof. J. Frankel

16. Rogoff (1996):Again, countries with high incomes per capita tend on average to have high real currency values, as judged by absolute PPP. API-120 - Prof. J. Frankel

17. Balassa-Samuelson relationshipre-estimated • Every 1% increase in real income/capitais associated on average with .38% real appreciation. • In any given year, many countries lie far off the line. • E.g., China’s RMB appeared “undervalued,” even relative to the B-S relationship, • by 25% in 2009. • What causes currencies to deviate from the B-S line? • Devaluation/revaluation, or • Fixed nominal exchange rate plus inflation or rapid productivity growth. • But gaps from the B-S line tend to correct 1/2-way per decade. API-120 - Prof. J. Frankel

18. Balassa-Samuelson estimated for 2000 Cross-section of 118 countries Log of real exchange value of country’s currency (1/Q) Log of real income 3 paths to an “undervalued” currency: (i) devaluation, (ii) low inflation, (iii) fixed exchange rate during a long period of rapid productivity growth. Frankel (2006): “On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,” Understanding the Chinese Economy, G.Illing, ed. (OUP).

19. Balassa-Samuelson estimated for 2005 The Balassa-Samuelson Relationship 2005 Source: Arvind Subramanian (2010), PB10-08, Peterson Institute for International Economics.Undervaluation of the 2005 RMB in the estimated regression = 26%. Compare to estimate for 2000 (Frankel 2005): 36%. As recently as 2009 (Chang 2012) :25% .

20. Balassa-Samuelson estimated for 2011 In 2014, the ICP released new absolute price data. “Is the Renminbi Still Undervalued? Not According to New PPP Estimates”by M.Kessler& A.Subramanian, PIIE, May 2014 API-120 - Prof. J. Frankel

21. API-120 - Macroeconomic Policy Analysis IProfessor Jeffrey Frankel, Kennedy School of Government, Harvard University

22. APPENDIX 1 -- PASSTHROUGH Jose Campa & Linda Goldberg (2005) Passthrough of exchange rate changes to import prices is low into the US market (especially in the SR). But for most other countries, the passthrough coefficient is above 50% even in the SR, and not statistically different from 1 in the LR. In most, the coefficient fell during the 1990s. Compositional differences of price indices (e.g., more weight on oil vs. autos) can alone explain part of the variation in passthrough coefficients. The passthrough coefficient depends on inflation & exchange rate volatility. API-120 - Prof. J. Frankel

23. Jose Campa & Linda Goldberg, 2005, “Exchange Rate Pass Through into Import Prices," Review of Econ. & Stats. API-120 - Prof. J. Frankel

24. Estimates from Jeffrey Frankel, David Parsley, & Shang-Jin Wei, 2012, "Slow Pass-through Around the World: A New Import for Developing Countries?” Open Ec. Rev. API-120 - Prof. J. Frankel

25. APPENDIX 1 – Balassa-Samuelson relationship Estimate of overvaluation/undervaluation measured relative to the Balassa-Samuelson line for 2009. Source: Gene Chang “Theory and Refinement of the Enhanced-PPP Model for Equilibrium Exchange Rates,” 2011. China: 25% undervaluation The RMB continued to appreciate in real terms. It has approximately completed its adjustment, as also shows up in the trade balance.http://www.jeffrey-frankel.com/2012/03/26/china-adjusts/ API-120 - Prof. J. Frankel