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Deviations from PPP. The LOP would not apply for differentiated products or products that are not traded internationally. The LOP does not take into account shipping costs or tariffs. The LOP could hold good for individual goods, but may not hold good if we use price indexes.

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Deviations from PPP

  • The LOP would not apply for differentiated products or products that are not traded internationally.

  • The LOP does not take into account shipping costs or tariffs.

  • The LOP could hold good for individual goods, but may not hold good if we use price indexes.


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Deviations from PPP

  • PPP is an equilibrium relationship between two endogenous variables

  • Endogenous variable: a variable whose value is determined by some given factors

  • Exogenous variable: a variable whose value is given to the economic system by an outside force, such as government or nature

  • Deviations in measured PPP will occur if prices and exchange rates change at different speeds


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Deviations from PPP

  • If there is some exogenous shock, changes in exchange rates precede change in prices

  • Graph illustrating how exchange rate will shift with receiving some economic news

  • Periods of economic news will be periods when PPP deviations are large, the exchange rate adjusts while prices lag behind

  • Also, periods dominated by news are likely to be periods involving relative price change


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Shifts in the foreign-exchange market and deviations

¥/$

S0

S1

A

PJA/PUS=140

120

B

D’

D

$0

$1

$


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Deviations from PPP

  • Another reason of deviations from PPP is because international trade involves lag between order and delivery.

  • Exchange rates are very difficult to forecast

  • Example: In September US importer agrees to buy books from UK for £1 per book. When contract was signed, books in US sell for $2 and current exchange rate E$/£=2. LOP holds here. This contract calls for delivery and payment in December of £1 per book and US importer expects exchange rate and prices to be unchanged, he expects PPP to hold at the time of payment. On December exchange rate is £1=$1.50.


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Deviations from PPP

  • An economist using LOP would compare prices of £1 and $2 with E$/£=$1.50, but $1.50 ≠ 2/1

  • Economist’s conclusion that there are important deviations from PPP

  • These deviations are spurious ( not genuine relationship)

  • We generate appearance of PPP deviations by comparing exchange rates today with prices that were set in the past


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“Overvalued” and “Undervalued” Currency

  • Overvalued currency: Currency worth more than PPP exchange rate.

  • Undervalued currency: Currency worth less than PPP exchange rate.

  • Currencies are said to be overvalued if they appreciated more than the difference between the domestic and foreign inflation rates


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“Overvalued” and “Undervalued” Currency

  • Overvalued dollar: foreign-exchange value of the dollar appeared to be too high relative to the inflation differentials between US and other developed countries

  • “Overvalued” currency means: exchange rate is not where it should be; if the free market of supply and demand factors are determining E, then the “overvalued” E is a free market equilibrium rate. This equilibrium is a temporary deviation from PPP

  • Figure 14.3


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“Overvalued” and “Undervalued” Currency

  • “Overvalued” dollar is hurting export-oriented industries

  • This problem was made visible by large balance-of-payments deficit


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“Overvalued” and “Undervalued” Currency

  • Lower labor productivity in developing countries could contribute to the appearance of overvalued currencies

  • Productivity and PPP were studied by Balassa and Samuelson, 1960


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Real Exchange Rates

  • Nominal exchange rate is the exchange rate that is actually observed on the foreign-exchange market

  • Real exchange rate is actually measured as: Ereal= E/(P/PF), or the nominal exchange rate adjusted for the ratio of home price level relative to the price level abroad

  • If absolute PPP always held, then the real exchange rate would equal 1