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Chapter_11_Prices_and_Exchange_Rates

Imperfect competition and legal obstacles many goods

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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. Price stickiness One of the most common assumptions of macroeconomics is that prices are “sticky” prices in the short run. PPP assumes that arbitrage can force prices to adjust, but adjustment will be slowed down by price stickiness.
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Limits to Arbitrage Assume costs associated with trade. Trade cost, c , assumed to be equal to some fraction of the unit cost of the good at its source. Price of good exported at home is P, but when sold in the foreign country price is: P(1+c) . Existence of trade costs affects arbitrage incentives of traders. Difference in prices in the two locations. P (Home price) and EP* (Foreign price) can be different. Arbitrage occurs only if difference in prices are large enough to compensate for trade cost.
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Limits to Arbitrage New arbitrage condition Traders buy good in Home and sell in Foreign only if EP* > P(1 + c) q = EP*/P > (1 + c) Traders buy good in Foreign and sell in Home only if P > (1 + c) EP* q = EP*/P < 1/(1 + c) New no arbitrage condition is:
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Limits to Arbitrage q fluctuates within a no-arbitrage band . Zero costs: c = 0, q = 1. PPP holds. Low costs: c is low. Deviations from PPP small. High costs: c is large. Deviations from PPP large .
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Limits to Arbitrage Trade costs in practice Transportation costs U.S. imports: freight costs from 1% to 27% of unit cost. Landlocked countries: prices 55% higher (vs. coastal) Trade policy Average tariffs: 5% (advanced), 10% (developing) Summary of estimates for advanced economies
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It’s Not Just the Burgers That Are Cheap Deviations in PPP are not random. Big Macs less expensive in poorer countries. Big Macs are 21% cheaper in Mexico and 53% less in Malaysia (vs. U.S.) Similar pattern with Starbucks tall lattes. Lattes cost 15% less in Mexico and 25% less in Malaysia, compared with the U.S. price. Reuters/Corbis
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It’s Not Just the Burgers That Are Cheap Explained by existence of nontraded goods. Big Mac is produced using a combination of traded goods (flour, beef and special sauce) and nontraded goods (cooks, cleaners, etc.). Dollar price of the Big Mac is strongly correlated with the local hourly wage (in dollars).
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It’s Not Just the Burgers That Are Cheap What about general prices? Most goods have nontraded and traded components, so the economy-wide price level should follow the same patterns observed above. Strong positive relationship between U.S. price level and GDP per person. Deviations in PPP vary systematically.
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The Big Mac index Currency comparisons, to go Jul 28th 2011, 14:35 by The Economist online A beefed-up version of the Big Mac index suggests that the Chinese yuan is now close to its fair value against the dollar
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Imperfect competition and legal obstacles Many goods are...

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