Chapter_11_Prices_and_Exchange_Rates

But the converse need not be true one could imagine a

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But the converse need not be true: one could imagine a case where a basket always costs a fixed amount more, say, 10% in common currency terms in one country than the other: In this case Absolute PPP fails, but Relative PPP holds.
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PPP as a Theory of the Exchange Rate In levels we have Absolute PPP: In rates of change we have Relative PPP
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Where Are We Now? The PPP theory, whether in absolute or relative form, suggests that price levels in different countries and exchange rates are tightly linked, either in levels or in rates of change. Do the data support the theory of purchasing power parity?
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Empirical Evidence on PPP According to relative PPP, the percentage change in the exchange rate should equal the inflation differential.
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Empirical Evidence on PPP According to absolute PPP, relative prices should converge over time.
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2. Deviations from PPP Identify the role of trade costs in arbitrage and purchasing power parity. Objectives
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The Big Mac Index For over 20 years The Economist magazine has used PPP to evaluate whether currencies are undervalued or overvalued. Recall, home currency is x% overvalued/undervalued when the home basket costs x% more/less than the foreign basket. The test is really based on Law of One Price because it relies on a basket with one good. Invented (1986) by economics editor Pam Woodall. She asked correspondents around the world to visit McDonalds and get prices of a Big Mac, then compute price relative to the U.S.
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The Big Mac Index The % deviation (+/–) from the US price measures the over/under valuation of the local currency based on the burger basket. Updated every year: In 2004 they tried the same exercise with another global, uniform product: the Starbucks tall latte. “Big Mac index” = q Big Mac - 1 = E $/local currency P local Big Mac P US Big Mac - 1
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The Big Mac Index
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What Explains Deviations from PPP? Transaction costs Recent estimates suggest transportation costs may add about 20% to the cost of goods moving internationally. Tariffs (and other policy barriers) may add another 10%, with variation across goods and across countries. Further costs arise due to the time taken to ship goods. Nontraded goods Some goods are inherently nontradable; Most goods fall somewhere in between freely tradable and purely nontradable. For example: a cup of coffee in a café. It includes some highly- traded components (coffee beans, sugar) and some nontraded components (the labor input of the barista).
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What Explains Deviations from PPP? Imperfect competition and legal obstacles Many goods are differentiated products, often with brand names, copyrights, and legal protection. Firms can engage in price discrimination across countries, using legal protection to prevent arbitrage E.g., if you try to import large quantities of a pharmaceuticals, and resell them, you may hear from the firm’s lawyers.
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