PPP

Question 1

5)Discuss the concept of Purchasing Power Parity (PPP).

Answer 1

Lets consider a force that moves an exchange rate in a very long run, in the long run economists believe that exchange rate adjust to equilibrate the cost of living across international boundaries. That is if country is finding their goods and services begin to be very expensive, then they will start importing cheaper goods and services from abroad instead, and that action will end that changing prices and exchange rates to the point in which the cost of living equality across international boundaries. We call this phenomena as PPP. It refers to which the purchasing power of your income in one country is the same as it is in another country, if you convert your income into a nominal exchange rate. That is prices and exchange rate are in relation such that the cost of living is same regardless of where you are. It is a sophisticated concept, so we will build up by bits and pieces.
Lets start with what economists call the Law of One Price

Question 2

Problems with PPP

Answer 2

1. Unidentical products across international boundaries
2. non tradable goods and services
3. No free flow of goods and capital between countries

Question 3

6)Outline and explain the difference between absolute and relative purchasing power parity (PPP).

Answer 3

Absolute PPP is based on Law of on Price, that states current (spot) exchange rate of between two currencies is simply a ratio of prices of identical products between countries. it is no a very dynamic concept, as a decision makers we would be more interested in seeing how the exchange rates move in future. Absolute PPP gives us a static concept, it is a picture of what is a current exchange rate. It does not tell us how the exchange rate is likely to behave in the future. Whether the currency is going to appreciate or depreciate is not answered by absolute PPP concept.

Relative PPP relates in the national price levels and exchanges. (macroeconomic variables INFLATION and CURRENCY VALUE) There is an inverse relation between inflation and currency value, however this is not the only factor that affect the exchange rate, hence other factors can be stronger to mitigate inflation pressure on the currency value. Using inflation we can estimate the exchange rate n period ahead.
P=SP* => take the log function from both side => logP=log(SP)=logS+logP => denote logX=x => p=s+p*
if we differentiate the equation with different price and exchange rate in terms of other time period lets say a year. Then we would have an equation dp=ds+dp*
where dp and dp* are inflation rates of domestic and foreign country respectively. and ds is a rate of currency depreciation.

Question 4

7)What do you understand by the PPP ‘puzzle’?

Answer 4

PPP came around to build worlds exchange rate system after the world war, when gold standard broke PPP was introduced as an alternative.
Researchers looked at law of one price, absolute and relative PPP.
They looked short run and long run whether the PPP really holds or not and most importantly introduced the extensions to help PPP more relevant.

The study found that

1. Real exchange rate possibly hold in the long run
2. PPP has half life which basically means that half of the deviation magnitude disappears in 3-5 years, the rest took much longer to disappear
3. Short run deviations are large and volatile, and concluded that it follows random walk

Question 5

9)Discuss the concept of the Law of One Price

Answer 5

Say a particular good that is freely tradable across international boundaries should have a same price whether you import them or buy them locally. That is P=SP*, Otherwise arbitrageurs will trade over price differences but eventually bring it down to this Price and Exchange rate relationships.
There are 4 things that can keep the law of one price of holding
a)what if trades were blocked between 2 countries
b)Goods might have a different qualities
c) No transaction costs

Question 6

10) Outline and explain the extensions to Purchasing Power Parity

Answer 6

Evidence shows that PPP does not really hold in the short term, huge deviations are observed in the short run however it tend to shrink over the long run, in theory it the P=SP* relation is absolutely valid but true price level is unobservable. The other problem is many goods and services are not of the same quality across countries.
PPP was not really predicting future exchange rates. As a result economists tried to give theoritical explanations why PPP doesn’t work.
(1)Balassa Samuelson Effect - traded vs non traded goods.
Assumptions ( 1.distinction of goods between tradable vs non, 2. people are paid by MPL, 3. for a given country nominal wage must equilase)
Technology advances more rapidly in goods manufacturing sector then service sector, productivity increases therefore driving up MPL relative to service sector, and wages=MPL across economy. => wages increase in service sectors while MPL stayed unchanged, => service sector price increases as time passes to equate MPL. Result is richer more advanced economies tend look less competitive in comparison of real exchange rate based on general price index.
(2)Trade costs and PPP adjustment - cost of moving goods around
(3)Trade costs - Iceberg Model we assume that importers pay the trade associated costs Pf=Pf/(1-t) and Pc=(1-t)Pc => Pc/Pf= (1-t)2Pc/Pf this could be a possible explanation why PPP fails.
(4)Exchange Rate Pass Through??? (BMW example)

Question 7

11) Based on your reading of Rogoff (1996), and any other material, can you offer possible explanations for the PPP ‘puzzle’?

Answer 7

Extensions should be the answer

Question 8

8) Discuss the Balassa Sameulson Effect

Answer 8

Assumptions
1.distinction of goods between tradable vs non tradable,
2. people are paid by MPL
3. for a given country nominal wage must equilase
Technology advances more rapidly in goods manufacturing sector then service sector, productivity increases therefore driving up MPL relative to service sector, and wages=MPL across economy. => wages increase in service sectors while MPL stayed unchanged, => service sector price increases as time passes to equate MPL. Result is richer more advanced economies tend look less competitive in comparison of real exchange rate based on general price index.

Question 9

Trade Costs- Iceberg Model

Answer 9

We assume that importers pay the trade associated costs Pf=Pf/(1-t) and Pc=(1-t)Pc => Pc/Pf= (1-t)2Pc/Pf this could be a possible explanation why PPP fails.
Even the 2 countries are identical price levels will still differ, without the fact any arbitrage opportunities.

Question 10

Exchange rate pass through - extension to PPP

Answer 10

Incomplete exchange rate pass through is one reason why a country’s real effective exchange rate can deviate from its PPP equilibrium level of 100%.
Ex: BMW is priced in US$ in the US. EUR appreciates by 10% versus the US$, price of a BMW car should rise by 10% in the US. But this does not happen in reality due to price elasticity of demand.

Question 11

Empirical research on PPP

Answer 11

1980s and 1970s the concept was heavily studied by researchers and found no evidence to support PPP, the real exchange rate appeared to be random walk. Recent decades with the help of advanced economic tools, PPP was found to be somehow working in the long run.