Absolute purchasing power parity theory:

1
Absolute purchasing power parity theory

• The price of any given item is the same wherever
  it is bought, provided that all prices are
  expressed in the same currency.
• For example, if the price in 1990 of a small
  electric kettle in Bangkok was Bht 200, and if
  the exchange rate in 1990 between the baht and
  the Australian dollar was Bht 20/A, then the
  Bangkok price is equivalent to A10.
• The theory of absolute PPP predicts that
  the price of a small electric kettle in
  Australian dollars in Sydney, or anywhere else in
  the world, will also be 10. If the actual price
  in Sydney in Sydney was 15, then the deviation
  from absolute PPP was 50

2
Arbitrage

• An arbitrage opportunity existsthat is, an
  arbitrage profit can be madeif the price
  difference between two places exceeds the costs
  of transporting the goods between the two places,
  after also allowing for any other costs, such as
  differences in wholesale and retail margins.
• The assumption that arbitrage profits get
  competed away is equivalent to the assumption
  that there are no free lunches. This assumption
  is the basis of PPP theory.

3
Cross rates in foreign exchange markets

• Since transactions and transport costs in FX
  markets are very small, absolute PPP does hold to
  a close approximation in these markets.
• For example, instead of comparing the prices of
  kettles in Bangkok and Sydney, compare the price
  of the US dollar in Bangkok and Hong Kong.
• In January 2007, the price of USD 1 in Bangkok
  was Bht 35.9, while the price of HK1 was Bht
  4.60. The price of USD 1 in Bangkok in terms of
  the Hong Kong dollar was therefore HK7.80
  (35.9/4.60). This was also the price of USD1 in
  Hong Kong to the nearest cent.

4
Empirical evidence on absolute PPP

• The theory of absolute PPP is obviously too
  extreme to be exactly true in general. If it was
  exactly true, there would never be an incentive
  to move goods from one place to another.
• At the very least, price differences between two
  places must reflect transport costs if goods are
  being transported from one place to another. In
  addition, price differences at the retail level
  must allow for differences between places in
  wholesale and retail margins that reflect
  differences in wages, rents and other costs.

5
Relative purchasing power parity theory

• The theory of relative PPP is that the price
  differences between places remain constant over
  time in proportional terms.
• That is, the deviations from absolute PPP
  between any two places does not change.
• The next slide gives hypothetical price data that
  could be used to test relative PPP. Later, we use
  real price data.

6
Illustrative example of testing relative PPP
using price of small electric kettle
7
Using price and exchange rate indices to test
relative PPP

• We can construct six price indexes, each based on
  1990 100
• The baht price of a kettle in Bangkok.
• The baht/US exchange rate.
• The US price of a kettle in Bangkok.
• The A price of a kettle in Sydney.
• The A/US exchange rate.
• The US price of a kettle in Sydney

8
Construction of price indexes

• The value of each index in any year is
  constructed by multiplying the relevant price in
  that year by 100 and dividing by the actual price
  in 1990.
• Notice that this is guaranteed to make the value
  of the index equal to 100 in 1990, as required.
• Since the value of the index in any year is a
  constant multiple of the corresponding price in
  that year, the proportionate change in the index
  between any two years must equal the
  proportionate change in the relevant price
  between those two years.

9
Price levels and price indexes
10
Conclusion from the hypothetical example

• Relative PPP predicts that although the US
  prices in Sydney and Bangkok may differ, the
  ratio of these prices should stay constant. It
  therefore predicts that the price indexes, based
  on the same year, should always be equal.
• That is, relative PPP predicts that columns (3)
  and (6) will be equal.
• Next, lets use real data on consumer price
  indexes and exchange rates.

11
Testing PPP with real data

• The next slide shows the CPI for the USA,
  Thailand (THA), Indonesia (IDN), Malaysia (MYS)
  and Australia (AUS) measured in local currency
  that is, without making any adjustment for
  exchange rate changes.
• These series can be thought of as corresponding
  to indexes 1 and 4 in the previous table the
  price index of consumption goods in local
  currency in different places.

12
(No Transcript)
13
Exchange rate changes

• The next slide shows the exchange rate indexes
  (local currency/) for the baht, rupiah, ringgit
  and A. These series correspond to indexes (2)
  and (5) in the previous table
• As predicted by PPP, there is at least a rough
  correlation between exchange rate changes and CPI
  changes. Most obviously, the very large increase
  in Indonesian prices compared to those in the
  other 4 countries has been accompanied by a very
  large devaluation of the rupiah against the other
  four currencies.

14
(No Transcript)
15

• The next slide shows the CPI indexes in local
  currency divided by the corresponding exchange
  rate indexes in local currency per US. It
  therefore shows the CPI indexes in each country
  converted in US. The CPI index divided by
  exchange rate index is gives the index of
  consumer prices in each country as viewed by a
  tourist from the USA. These indexes correspond to
  series (3) and (6) in the illustrative example.
  They should be equal under relative PPP.

16
(No Transcript)
17

• Does PPP hold? Exactly? Approximately?
• Look back at the previous figure. What, if
  anything, does it tell you about where the cost
  of living is lowest and where it is highest?
  Think carefully the question is a bit of a
  trick!
• It doesnt tell you anything about these
  questions.

18

• Note that in 1990, all series are equal to 100 by
  construction. To know where a has the highest
  purchasing power, you need to do direct
  comparisons of the price of a fixed bundle of
  goods at some given date. An example is The
  Economists Big Mac index. A broader study of
  cross country prices, financed by the World Bank
  and others, indicates that the purchasing power
  of a dollar in developing countries is often
  about three times higher (or even more) than in
  the richest country.

19
The real exchange rate (RER)

• The real exchange rate can be defined as the
  price of foreign goods in term of domestic goods.
  Its units are therefore units of domestic goods
  per unit of foreign good.
• As an illustration, call the domestic good rice
  and the foreign good whisky. The real exchange
  rate is therefore measured in kilograms of rice
  per litre of whisky.
• This is not the only way of defining the RER, but
  it is the one we shall use in this course.

20

• Movements in the RER between Thailand and the USA
  can be estimated as movements in the US price
  index of Thai goods divided by movements in the
  US price index of US goods.
• RER P/eP
• Where P is the price of Thai goods in baht, e is
  the exchange rate in baht/ and P is the US
  price index in dollars.

21
Relative PPP and the RER

• Given this definition, changes in the RER
  correspond to deviations from relative PPP. If
  relative PPP held exactly, the RER would be a
  constant, and an index of the RER would always be
  equal to 100.
• Note that the last graph shown plotted P/e for
  Thailand, Indonesia, Malaysia and Australia and
  P for the USA. It showed that between 1990 and
  2003 there was real depreciation in all the other
  countries relative to the USA. American goods
  were getting more expensive relative to goods
  from each of the other countries.
• The good news for the USA was that its real
  appreciation reflected the strength of the US
  economy. The goods news for the other countries
  was that their goods were getting more
  competitive relative to US goods.