Prices and exchange rates
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Prices and Exchange Rates. Purchasing Power Parity. Purchasing Power Parity. Similar goods tend to sell for similar prices worldwide. Law of One Price

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Prices and Exchange Rates

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Prices and exchange rates

Prices and Exchange Rates

Purchasing Power Parity


Purchasing power parity

Purchasing Power Parity

  • Similar goods tend to sell for similar prices worldwide.

  • Law of One Price

    All goods must sell for the same price worldwide when converted into a common currency (if there is no transportation costs and no trade barriers).

    That isE$/¥= PUSi / PJi for all i,

    where PUSi = price of good i in US

    PJi = price of good i in Japan


Purchasing power parity ppp

Purchasing Power Parity (PPP)

  • Absolute PPP

    The equivalence of the exchange rate to the ratio of the foreign and domestic price levels

    That isE$/¥= PUS/ PJ

    where PUS= price level of US

    PJ= price level of Japan

    price level = price of a reference commodity basket


Purchasing power parity ppp1

Purchasing Power Parity (PPP)

  • Relative PPP

    The equivalence of the percentage change in the exchange rate to the inflation differential (the difference of the foreign and domestic changes in price levels).

    That is^E$/¥= ^PUS - ^PJ

    or ^E$/¥= US - J

    where ^()= % change in ()

    US= inflation rate in US

    J= inflation rate in Japan


Purchasing power parity ppp2

Purchasing Power Parity (PPP)

  • The law of one price implies but is not implied by PPP.

  • Absolute PPP implies but is not implied by Relative PPP.


Overvalued and undervalued currencies

“Overvalued” and “Undervalued” Currencies

  • “Overvalued”currency: Currency worth more than PPP value

  • “Undervalued”currency: Currency worth less than PPP value

  • In the early 1980s, may people said that dollar was overvalued.


Inflation and relative price changes

Inflation and relative price changes

  • Relative price changes  real shocks

  • Inflation  nominal shocks

  • Relative price movements are short run phenomena and tend to cancel out over time.

  • In the long run, inflation dominates exchange rate movements.

  • PPP holds better in the long run than in the short run.


Inflation and relative price changes1

Inflation and relative price changes

  • PPP holds better for high-inflation countries.

  • Even if law of one price holds perfectly for individual goods, PPP could be violated for a price index.

  • Data does not give much empirical support to PPP.


Factors explaining the poor performance of ppp

Factors explaining the poor performance of PPP

  • Trade restrictions and transport costs

    • For some goods, transport costs are so large that they can never be traded internationally.  Nontraded goods (nontradables)

    • Examples: construction (e.g. homebuilding), services (e.g. haircut), and domestic transportation (e.g. bus and train services).

    • Exception: South Korean construction firms in Middle East in 70s and 80s.

    • Local demand and supply determine their prices.

    • 50% of US GNP is nontradables.


Factors explaining the poor performance of ppp1

Factors explaining the poor performance of PPP

  • Imperfectly competitive markets

    Price discrimination: sells a commodity at different prices in different countries.

  • Differences in price level measures

    Different baskets in different countries.


Prices and exchange rates

City

Man’s Haircut

Woman’s Cut

And Blow Dry

Country’s per

Capita Income 1988

Zurich

34.47

36.83

27,500

Tokyo

27.78

46.40

21,020

New York City

21.66

27.00

19,840

Frankfurt

13.64

20.20

18,480

Paris

23.87

36.81

16,090

London

17.32

28.60

12,810

Sydney

18.05

25.99

12,340

Hong Kong

14.06

18.75

9,220

Sao Paulo

7.33

15.95

2,160

Mexico City

6.50

9.94

1,760

Moscow

6.78

9.57

NA


Why haircuts prices are lower in poorer countries

Why haircuts prices are lower in poorer countries?

  • Assume:

  • Productivity in the tradables sector is higher in developed countries than in developing countries.

  • Productivity in the nontradables sector is similar in both groups.

  • Prices of tradables are the same in both groups.


Why haircuts prices are lower in poorer countries1

Why haircuts prices are lower in poorer countries?

  • Then: in developing countries

  •  lower productivity in tradables

  •  lower wage relative to developed countries

  •  lower costs for nontradables

  •  lower prices of nontradables

  • Relative prices of nontradables will increase as real per capita income increases.


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