LECTURES 8 & 9: PURCHASING POWER PARITY (PPP)

EMPIRICAL TESTS OF PPP

Motivating questions:

How integrated are goods markets internationally?

How rapidly do prices adjust?

ITF-220 Prof.J.Frankel

PPP: ALTERNATIVE DEFINTIONS

Absolute PPP : P ≡ price of a basket of goods in domestic currency

esp. from the World Bank’s International Comparison Program.

• RER = 1, where real exchange rate RER ≡ E

• P = E P*• E =

• In logs: e = p - p*.=

Prof. Jeffrey Frankel, Harvard Kennedy School

PPP: ALTERNATIVE DEFINTIONS (continued)

Relative PPP CPI ≡ is a price index, expressed relative to an arbitrary base year

e.g., “CPI2000 ≡ 100.0” (from national agencies).

Define real exchange rate Q ≡ E .• Q is constant (at ),

• CPI (E)(CPI*) . • In logs, Δe = Δ cpi – Δ cpi* (relative to some base year).

• Annual depreciation = π - π* .

or E =

API120 - Prof. J.Frankel

PPP: EMPIRICAL QUESTIONS

• Does PPP hold: in the short run? in the long run?

• What is the estimated speed of adjustment to the LR?

• What is the test’s “statistical power”?

• Are PPP deviations: • related to variation in nominal exchange rates?

- Can one infer causality?- Is Var (q) related to currency regimes?

• related to geography?- To distance? To borders?

• Does the Law of One Price hold better in some sectors than others?- Commodities vs. Manufactures & Services- Tradables vs. Nontradables- Imports. (Is there full pass-through?)

API120 - Prof. J.Frankel

PPP in a sense holds well in hyperinflations:

The cumulative change in E corresponds to the cumulative change in CPI.

SPECIFICATION OF PPP TEST :the real exchange rate as an autoregressive process

(random walk, or unit root)

(full adjustment to PPP)

(gradual adjustment to PPP).

Common finding in tests of 1980s: can’t reject H0 .

True problem: Insufficient power in the tests, due to insufficient data.Since 1990, studies have sought more data.

AltH

API120 - Prof. J.Frankel

ttt uqkq 11:0 H

1H 0: 10:

where ut ≡ random disturbance with E(ut) = 0.

API120 - Prof. J.Frankel

With 100 or 200 years of datait is not hard to reject a random walk, i.e., to detect regression to the mean.

qt

API120 - Prof. J.Frankel

Studies with long time series:

Time Period

Estmt.δ

Speed of Adjustment

Half-life(years)

JF (1990) 1869-1987 .84 .16 4

Updated WTP (2007) 1791-2005 .88 .12(s.e.=.05)

4

Lothian & M. Taylor (1996) 2 centuries 3-5

Alan Taylor (2002)19 currencies 1870-1996 .79 .21

(s.e.=.01)3.4 – 4.1

Pappell & Prodan (2005) 1870-1998 1-2

Cross-country Number of panel data studies: countries

Frankel & Rose (1995) 150 4Wei & Parsley (1998) 14 4-5Choi, Mark & Sul (2004) 21 5.5

API120 - Prof. J.Frankel

Taylor spliced together 100+ years of data for 20 currencies: 1870-1996

One lesson:reversionto LR Q

API120 - Prof. J.Frankel

Three useful kinds of empirical evidence:

• The pattern of movement in real exchange rates:• band or threshold• Random Walk• trend• AR .

• Effects of exchange rate regime on variability in Q.

• Tests of Law of One Price for narrowly defined goods.

PPP clearly fails in the short run.

What is HAlt? Sticky prices? How can we tell?

Four patterns ofdeviation from PPP

and their likely origins:

a) Band <= barriers to trade

b) Random walk <= shifts in terms of trade

c) Trend <= Balassa-Samuelson effect

d) Autoregression <= sticky prices.

Band Random Walk

Trend Autoregression

Q

Q ≡

Q ≡

Q ≡

Q ≡

Q ≡

API120 - Prof. J.Frankel

Var(et) and Var (qt) are correlated.

Is it coincidence? No, it can’t be: Every time a regime switch raises variability of nominal exchange rates, it also raises variability of real exchange rates.

· Pre- and post-1973 (Fig. 19.4)

· Inter-war period (Eichengreen, 1988): 1922-26 float vs. 1927-31 fix

· Post-war regimes (Mussa, 1986): - Canadian float in the 1950s - Ireland regime changes (see appendix table)

· A century of PPP (A.Taylor, 2002): 1870-1914 Gold standard 1914-45 Interwar 1946-71 Bretton Woods 1971-96 Float

When nominal exchange rate

variability (¥/$) went upwith floating,

real exchange rate variability

went upin tandem.

Coincidence?

Figure 19.4

Nominal & real exchange rates both became more volatile after 1973.

Monthly Changes in Real Japanese Yen /Dollar Rate

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Monthly Changes in Nominal Japanese Yen /Dollar Rate

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API120 - Prof. J.Frankel

The final nail in the coffin:Exchange rate variability across a century of regimes

Prof. Jeffrey Frankel

Variability of real exchange rate

Variability of nominal exchange rate

Again, each time a more flexible regime raises nominal variability, it raises real variability too.

1870-1996

Each observation is a country-regime. (Adapted from A.Taylor, 2002)

Mussa (1986):

Each time Ireland changed its exchange rate arrangements (₤, $, DM), bilateral realexchange rate variability has followed bilateral nominal exchange rate variability.

API120 - Prof. J.Frankel

Appendix: Another comparison of regimes

Looking ahead -- Lecture 9: FAILURES OF PURCHASING POWER PARITY (PPP)

Tests of the Law of One PriceNTGsCommoditiesManufacturesBig Mac hamburgersImports

Barriers to International Integration Transportation costs Tariffs & non-tariff trade barriers Border frictions Currencies

Non-Traded Goods -- The Balassa-Samuelson Effect