tests of the law of one price –ntgs –commodities –manufactures –big mac hamburgers...
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• Tests of the Law of One Price– NTGs– Commodities– Manufactures– Big Mac hamburgers– Imports
• Barriers to International Integration– Transportation costs– Tariffs & non-tariff trade barriers – Border frictions – Currencies
• Non-Traded Goods -- The Balassa-Samuelson Effect
Lecture 9: FAILURES OF PURCHASING POWER PARITY (PPP)
API-120, Prof.J.Frankel, Harvard Kennedy School
Tests of the Law of One Price (LoOP)
1. Internationally Traded vs. NonTraded Goods & Services, e.g., haircuts & housing;
little scope for arbitrage.
2. “Customer goods” vs. “auction goods,” agricultural & mineral commodities -- where arbitrage works well.
3. Disaggregated manufactures e.g., Giovannini (1988), Engel (1993) .
4. In reality, even TGs have a NTG component (distribution & retail), & vice versa.
- Some recent models make the TG/NTG line endogenous: Bergin (2003); Ghironi & Melitz (2004)
- McDonalds hamburgers. The Economist (1986- ), Parsley & Wei (2003).
5. Pass-through of import prices. Big recent literature.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Prices of nontraded services vary widely.
Notice that they are lower in poorer (low-wage) countriesthan in high-wage countries.
NTGs
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
For a homogeneous mineral commodity such as gold,international arbitrage equalizes prices quite closely.
Commodities Kenneth Rogoff, “The Purchasing Power Parity Puzzle, J. Ec.Lit., 1996.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Even in a manu-facturing sectoras disaggregatedand seeminglystandardized asball bearings, the relative price in Japan varies
Manufactures
(1) widely, and (2) in correlation with the ¥/$ exchange rate.
Alberto Giovannini. “Exchange Rates and Traded Goods Prices,” J.Int.Ec.,1988.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Big Macs are partly traded (ingredients) & partly nontraded (cooking & retail).
Their price varies widely across countries.
The price tends to be higher in rich countries (e.g., Europe & Japan), than in developing countries (e.g., China)
and in countries with overvalued currencies (e.g., Argentina in 2000).
Big Macs
• Pass-through coefficient ≡ % change in local price resulting from a given % change in exchange rate.
• Pass-through is greatest for imported goods at dock, but less for prices of the same goods at retail level.
• Reason: local distribution & retail costs.
• The passthrough to prices of local substitutes is again less; and is still less to the CPI. Exchange Rate Passthrough
to Domestic Prices
0.2
0.4
0.6
at the dock imported goodprices
localcompetitor
prices
consumer priceindex
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76 developing and other countries, 1990-2001
Source: Frankel, Parsley & Wei (2012)
Pass-through to import prices
Passthrough coefficientsfor less developed countries > for rich, historically.
Source: Frankel, Parsley & Wei (2012)
Passthrough and Income (Average 1990-2001)
(Country Grouping Based on World Bank Classification)
12 countries
36 countries
28 countries
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
Low Income Middle Income High Income
pass
thro
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fici
ent
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
BARRIERS TO INTERNATIONAL INTEGRATION OF GOODS MARKETS
• Transportation costs
• Tariffs & non-tariff trade barriers
• Border frictions
• Currencies
NON-TRADED GOODS (NTGs)
• The Balassa-Samuelson effect
• Deviations from the Balassa-Samuelson line
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
By 1914, low transport costs, free trade in the UK, & the Pax Brittanica, allowed arbitrage between the US & UK in wheat.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
In agricultural products, high trade barriers are still retained, preventing price arbitrage.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
CROSS-BORDER TRADE BARRIERS: KEY FINDINGS (after controlling for trade policy & geographic variables)
Even across the Canadian-U.S. border,
Looking at trade among large sample of countries,
Gravity model of volume of trade shows:
firms trade with fellow citizens 20 x as much as cross-border (5-10 x, after controlling for FTA, etc.) -- McCallum (1995), Helliwell (1998) ;
different currencies, in particular, cut trade sharply-- Rose (2000);
Evidence of arbitrage in price differentials shows:
frictions in crossing the border >> frictions in going from one end of country to the other -- Engel & Rogers (1996) .
different currencies, in particular, explain some of the border frictions -- Parsley & Wei (2001)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
Rose (2000), the most influential empirical paper in international monetary economics in the last 12 years:
Applying the gravity model of bilateral trade to a large sample of countries reveals
(exp(1.2)=3).
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.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
NonTraded Goods & Services
Why is the cost of living so high in
Tokyo and so low in Mumbai?
Why was Buenos Aires more
expensive than Paris or Frankfurt
in 2001?...
In 2004, Tokyo was still very
expensive.
But Buenos Aires had fallen
far below Paris or Frankfurt.
Why?The peso collapsed in 2002.
One important application of the TG-NTG model,particularly for long-run trends.
The Balassa-Samuelson effect:
(PNTG/PTG), and therefore Q, riseswith countries’real incomes.
Usual B-S reason:Productivity growthtakes place in the TGsector, reducing prices there relative to wages and PNTG.
Original Balassa article (1964)
Distinguishng TGs from NTGs is difficult in practice.
Estimates of tradability calculated for about 200 products, as the worldwide trade/output ratio, relative to average tradability of all products
Source: Robert E. Lipsey & Birgitta Swedenborg, 2010, Review of World Economics. http://www.nber.org/papers/w13239
Data: 20 OECD countries, 1985-1999, from UNIDO (2000) & US.Commerce Dept. (2002).
Tradablegoods
Non-Tradable
Goods
In almost all countries, the ratio of NTG prices to TG prices rises over time(the “Baumol effect”).
Japan had the strongest trend during the post-war period.
If more than 2% of the sector is traded, it must be tradable.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
The originalBelassa articleshowed1960 levels.
The countries with the strongest productivity growth tend to show the strongest upward trend in the relative prices of NTGs(1970-1985) .
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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 - Macroeconomic Policy Analysis I , Prof.J.Frankel
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 appears “undervalued,” even relative to the B-S relationship.– Chang (2011) estimates 25% on 2009 ICP stats.
• What causes currencies to deviate from the B-S line?– Devaluation/revaluation– Fixed nominal exchange rate plus either inflation or rapid productivity growth
• Gaps from the B-S line tend to correct 1/2-way per decade.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
loginc00
Fitted values logRER00 CHN
6.17768 10.6917
-2.15096
.370385
CHN
Balassa-Samuelson estimated for 2000Cross-section of 118 countries
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. (Oxford U. Press).
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.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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.
Jose Campa & Linda Goldberg, 2005, “Exchange Rate Pass Through into Import Prices," Review of Econ. & Stats. 87, 4: 679-90.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
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., 23(2): 213-51.
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
Appendix 2: Updated estimate of real valuation measured relative to Balassa-Samuelson
Source: Gene Chang (Aug. 2011)
Copyright 2007 Jeffrey Frankel, unless otherwise noted
API-120 - Macroeconomic Policy Analysis I Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
APPENDIX 1 – Balassa-
Samuelson relationship
China: 25% undervaluation
Estimate of overvaluation/undervaluationmeasured relative to the Balassa-Samuelson line
Source: Gene Chang“Theory and Refinement of the Enhanced-PPP Model for Equilibrium Exchange Rates,” Aug. 2011.