International Financial Markets Prices and Policies Second Edition

International Financial Markets Prices and Policies Second Edition © 2001 Richard M. Levich 4 Mc. Graw Hill / Irwin International Parity Conditions: Purchasing Power Parity

4 -2 Overview w The Usefulness of Parity Conditions in International Financial Markets è An Overview of International Parity Conditions in a Perfect Capital Market w Purchasing Power Parity in a Perfect Capital Market The Law of One Price è Absolute Purchasing Power Parity è Relative Purchasing Power Parity è The Real Exchange Rate and Purchasing Power Parity 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved. Mc. Graw Hill / Irwin è

4 -3 Overview w Relaxing the Perfect Capital Market Assumptions Transaction Costs è Taxes è Uncertainty è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4 -4 Overview w Empirical Evidence on Prices and Exchange Rates Empirical Methods, or How to Test a Parity Condition è Evidence on the Law of One Price è Relative PPP: Evidence from Recent Quarterly Data è Relative PPP: Evidence from Hyperinflationary Economies è Relative PPP: Evidence from Long-Run Data è Empirical Tests of PPP: Is the Real Exchange Rate Constant? 2001 Mc. Grawè Empirical Tests of PPP: The by The Mc. Graw-Hill Companies, Inc. All rights reserved. Hill / Irwin Final Word è

4 -5 Overview w Policy Matters - Private Enterprises The Role of Parity Conditions for Management Decisions è Purchasing Power Parity and Managerial Decisions è Purchasing Power Parity and Product Pricing Decisions è w Policy Matters - Public Policymakers Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 -6 in International Financial Markets w Parity conditions can be thought of as international financial “benchmarks” or “breakeven values”. è They are the defining points where the decisionmaker is indifferent between the two strategies summarized by the two halves of the parity relation. w Because parity conditions rely heavily on arbitrage, a violation of parity often implies that a profit opportunity or cost advantage is available to the decision-maker. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 -7 in International Financial Markets w We begin our analysis of international parity conditions by assuming a perfect capital market (PCM) setting: no transaction costs è no taxes è complete certainty è w Based on the PCM assumptions, there are four principle parity conditions in international finance, of which only three are independent. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 -8 in International Financial Markets 1 a. Purchasing Power Parity Absolute Version The price of a market basket of U. S. goods equals the price of a market basket of foreign goods when multiplied by the exchange rate. Driven by arbitrage in goods. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 -9 in International Financial Markets 1 b. Purchasing Power Parity Relative Version The percentage change in the exchange rate equals the percentage change in U. S. goods prices less the percentage change in foreign goods prices. Driven by arbitrage in goods. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 - 10 in International Financial Markets 2. Interest Rate Parity The forward exchange rate premium equals (approximately) the U. S. interest rate minus the foreign interest rate. Driven by arbitrage between the spot and forward exchange rates, and money market interest rates. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 - 11 in International Financial Markets 3 a. Fisher Parities Fisher Effect (Fisher Closed) For a single economy, the nominal interest rate equals the real interest rate plus the expected rate of inflation. Driven by desire to insulate the real interest against expected inflation, and arbitrage between real and nominal assets. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 - 12 in International Financial Markets 3 b. Fisher Parities International Fisher Effect (Fisher Open) For two economies, the U. S. interest rate minus the foreign interest rate equals the expected percentage change in the exchange rate. Driven by arbitrage in bonds denominated in two currencies. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

The Usefulness of Parity Conditions 4 - 13 in International Financial Markets 4. Forward Rate Unbiased Today’s forward premium (for delivery in n days) equals the expected percentage change in the spot rate (over the next n days). Driving force: Market players monitor the difference between today’s forward rate (for delivery in n days) and their expectation of the future spot rate (n days from today). Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 14 in a Perfect Capital Market w Purchasing power parity (PPP) is built on the notion of arbitrage across goods markets and the Law of One Price. w The Law of One Price is the principle that in a PCM setting, homogeneous goods will sell for the same price in two markets, taking into account the exchange rate. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 15 in a Perfect Capital Market w Let PUS and PUK represent the weighted average price level for goods in the U. S. and U. K. market baskets respectively. w Absolute PPP predicts that these two price measures will be equal after adjusting for the exchange rate: PUS = S$/£ PUK w Absolute PPP requires that the consumption baskets are identical across the two countries. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4 - 16 Purchasing Power Parity in a Perfect Capital Market Suppose absolute PPP is violated. Introduce K so that: PUS, t +1 = K S$/£, t +1 PUK, t +1 PUS, t = K S$/£, t PUK, t (a) (b) p. US = s + p. UK + s p. UK For small % changes, or when continuous rates are used, the cross-product term s p. UK can be ignored. % exchange rate = % U. S. prices – % U. K. prices Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 17 in a Perfect Capital Market w Often, we are interested in the level of the exchange rate that satisfies PPP. w The PPP spot rate reestablishes PPP relative to a base period. It is the exchange rate that would just offset the relative inflation between a pair of countries since the base period. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 18 in a Perfect Capital Market Example Base period nominal exchange rate = $1. 50/£ Prices of U. S. goods had risen by 8% Prices of U. K. goods had risen by 4% PPP spot rate = $1. 50/£ 1. 08/1. 04 = $1. 5577/£ w A nominal exchange rate of $1. 5577/£ would reestablish PPP in comparison to the base period. w Nominal exchange rates greater than $1. 5577/£ represent £ “overvaluation” ($ undervaluation), while rates less than $1. 5577/£ represent $ “overvaluation” (£ undervaluation). Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 19 in a Perfect Capital Market PPP conditions do not imply anything about causal linkages between prices and exchange rates or vice versa. w Both prices and exchange rates are jointly determined by other variables in the economy. w PPP is an equilibrium condition that must be satisfied when the economy is at its long-term equilibrium. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 20 in a Perfect Capital Market w Real magnitudes are constructed from nominal magnitudes by adjusting for the appropriate price levels or inflation rates. Example Nominal income in 2000 (base year) = $55, 000/year Real = $55, 000/year = 220 market baskets/year income $250/market basket Nominal income in 2001 = $60, 500/year Real = $60, 500/year = 224. 07 mkt baskets/year income $270/market basket Index (2001) = 224. 07/220 = 1. 0185 Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 21 in a Perfect Capital Market w The real exchange rate is calculated by correcting the nominal exchange rate for the price levels in the two countries. w When absolute PPP holds: $1. 50/£ = $1, 500/US good £ 1, 000/British good . LHS = 1 US good / British good RHS w When PPP holds, the real exchange rate is constant. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Purchasing Power Parity 4 - 22 in a Perfect Capital Market w An index of the real exchange rate is defined as: Spot (Real, t) = Spot (Nominal, t) Spot (PPP, t) . Example Today’s spot exchange rate is $1. 80/£ PPP spot rate is $1. 50/£ Real exchange rate index = 1. 80/1. 50 = 1. 20 w At 1. 20, the £ is “overvalued” on a PPP basis. 1. 0 British good can be exchanged for 1. 2 U. S. goods. So, sellers of British goods have “lost competitiveness” on international markets. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Relaxing the 4 - 23 Perfect Capital Market Assumptions w Transaction Costs è Transport and menu costs lead to a neutral band around the PPP line, within which it is not profitable to execute arbitrage transactions. w Taxes è Tariffs have an effect similar to transaction costs. w Uncertainty è Arbitrageurs will seek a greater profit to compensate for risks, thus leading to a wider band around the PPP line before arbitrage becomes profitable. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 24 Prices and Exchange Rates w A parity condition can be viewed as a 45° line passing through the origin with the LHS and RHS variables plotted on the x and y axes. w Thus, parity conditions can be tested by running the simple linear regression: LHSt = + RHSt + t w Parity holds when the data cannot reject a null hypothesis where = 0, = 1, and the error terms have classical properties. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 25 Prices and Exchange Rates w In reality, seemingly “homogeneous” goods may differ in a number of important respects which undermine tests of the Law of One Price. w One test of the Law of One Price is the Big Mac index, which has been published annually in The Economist since 1986. è It was devised as a light-hearted guide to whether currencies are at their “correct” level, based on PPP. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4 - 26 Empirical Evidence on Prices and Exchange Rates Mc. Graw Hill / Irwin Source: The Economist, April 29, 2000 Malaysia Hungary Hong Kong Russia Thailand Brazil Indonesia Canada Italy Taiwan Euro Area Argentina France South Korea Britain Switzerland Ratio of Big Mac Prices in US$ Relative to U. S. Price is $2. 51/Big Mac 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 27 Prices and Exchange Rates w With the rise of e-commerce, investigating the Law of One Price becomes easier and violations more puzzling. è A recent Wall Street Journal article highlighted the case of a popular book that sold for $16. 20 at Amazon. com (U. S. ), for $13. 52 at Amazon. co. uk (Britain), and for $27. 00 at Amazon. de (Germany). Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 28 Prices and Exchange Rates w To examine the relative PPP condition, we can compare the exchange rate change to the contemporaneous inflation differential: st = + (p$ – p. DM)t + t w It seems that PPP is a poor explanation of exchange-rate changes on a period-by-period basis. w However, there is a tendency for PPP to reassert itself as time passes (mean reversion). Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Quarterly Deviations from Relative PPP 4 - 29 CPI: Germany and the United States, 1973 -1999 = 0. 003 = 0. 15 R 2 = 0. 003 N = 107 (0. 007) (0. 83) D–W = 1. 83 % Deviations Spot Rate Changes Average Inflation Difference Mc. Graw Hill / Irwin (US-German) Inflation 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 30 Prices and Exchange Rates w During a hyperinflation period, even the demanding regression-style test tends to support PPP. This is due in some degree to dollarization. w Long-run data indicated that the real exchange rate did not evolve as a random walk, but demonstrated a clear tendency to revert back to its central value. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 31 Prices and Exchange Rates w Note that the real exchange rate itself may not be constant. It may change on a permanent basis if a real shock affected one country but not its trading partners. è The Balassa-Samuelson hypothesis states that countries that have experienced high productivity gains, higher real income growth and higher real incomes should have appreciating real exchange rates. è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

Empirical Evidence on 4 - 32 Prices and Exchange Rates w Empirical tests confirm that. . . PPP is a poor descriptor of exchange rate behavior in the short run, where the rates are quite volatile and domestic prices are somewhat sticky. è But in longer-run analysis, it appears that PPP offers a reasonably good guide. è Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4 - 33 Policy Matters - Private Enterprises w If managers can identify the deviations from parity that are growing larger or likely to persist, then profit-maximizing decisions can be made. w Knowing that deviations from parity occur, managers may adopt strategies that reduce their exposure to the risks of such deviations. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4 - 34 Policy Matters - Private Enterprises w In a number of instances, international price differentials in some commodities have been both large and persistent. w More interesting perhaps are the international price differentials across “branded goods” like Mc. Donald’s Big Mac and The Economist, whose prices are set by brand managers rather than by market forces. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.

4 - 35 Policy Matters - Public Policymakers w Deviations from PPP, by definition, measure changes in a country’s international competitiveness, and reveal whether a currency is overvalued or undervalued relative to a simple standard. w However, there are limitations on the usefulness of PPP in policy decisions, as real macroeconomic disturbances call for a change in the real exchange rate. Mc. Graw Hill / Irwin 2001 by The Mc. Graw-Hill Companies, Inc. All rights reserved.