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Purchasing Power Parity Notes

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Pip Reeve IEMT10W6T5 "Purchasing power parity works in the long run but not in the medium or short run." Discuss. Absolute purchasing power parity (PPP) occurs when the exchange rate between two countries' currencies is equal to the ratio of the countries price levels. Essentially, this means that, for a given basket of goods, the purchasing power of different currencies is equalised. This can be summarised using the following equation: E$/€ = PUS/PE where E$/€ is the exchange rate between dollars and euros. PUS is the dollar price of a basket of goods and PE is the euro price of the same basket of goods. Relative PPP, on the other hand, occurs when the percentage change in exchange rates between two countries over a period equals the difference between the percentage changes in national price levels. Rogoff suggests that, 'while few empirically literate economists take PPP seriously as a short term proposition, most instinctively believe in some variant of PPP as an anchor for long run real exchange rate.'1 A number of problems are commonly mentioned in textbook theory which suggest why PPP may not work in practice. Firstly, the existence of transport costs means that it is simply not economical to transport some goods, non-tradeables, such as haircuts. If the transport costs are large relative to the production cost it is unlikely that a good will be traded. The purchasing power of any country will decrease if the prices of its non-tradeables increase, as reflected in an increase in inflation measured by the Consumer Price Index (CPI). Secondly, government trade restrictions such as tariffs can increase the cost of importing goods and hence reduce the likelihood of equalisation of purchasing power of different countries. Thirdly, departures from free competition can lead to a failure of the PPP to hold. This will occur if firms engage in discriminatory pricing, where they charge different prices to different countries. However, the 'ability to price discriminate across markets may be very limited in practice.'2 For example, there is the possibility of a 'grey market' in certain markets, such as in electronics, where 'goods are purchased in low price countries for immediate resale in countries where the manufacturer in attempting to charge a higher price.' 3Finally, there are international differences in price level measurement, for example, the Japanese would put more emphasis on Sushi in a basket of goods, which will, of course, affect the price level in the PPP equation. Rogoff argues that the high degree of persistence in the real exchange rate is something of a puzzle. This is because, if we take as given the fact that real shocks cannot account for the major part of the short run volatility of real exchange rates (since it seems incredible that shocks to real factors such as tastes and technology could be so volatile) and that nominal shocks can have strong effects only over a time frame in which nominal wages and prices are sticky, it is hard to explain the high degree of persistence of the real exchange rate. It is perhaps possible to reconcile this view in the long run, but not in the short run. In the past, 'much of economists' faith in PPP derives from a belief that over most of the past century, price level movements have been dominated by monetary factors.' 4In the short run, the failure of PPP can be, in part, attributed to nominal price rigidity. So, as financial and monetary shocks buffet the nominal exchange rate, the real exchange rate will also change in the short run. However, as Rogoff suggests, 'if this were the entire story one would expect substantial convergence to PPP over one to two years, as wages and prices adjust to a shock.' This is confirmed by Rogoff, 'if a significant fraction of total exchange rate volatility is caused by monetary and financial shocks, then one would expect deviations to PPP to die out at a rate faster than 15% per year.' So, this suggests that PPP is not a short run relationship as price level movements do not begin to offset exchange rate swings on a short term basis. Furthermore, Krugman notes that 'when disturbances occur in output markets, the exchange rate 1 'The PPP puzzle' Rogoff 1996 2 'Perspectives on PPP and long run real exchange rates' Froot & Rogoff 3 'Perspectives on PPP and long run real exchange rates' Froot & Rogoff 4 'Perspectives on PPP and long run real exchange rates' Froot & Rogoff

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