Chapter_11_Prices_and_Exchange_Rates

Price stickiness one of the most common assumptions

Info icon This preview shows pages 28–37. Sign up to view the full content.

View Full Document Right Arrow Icon
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.
Image of page 28

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
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.
Image of page 29
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:
Image of page 30

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
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 .
Image of page 31
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
Image of page 32

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
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
Image of page 33
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).
Image of page 34

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
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.
Image of page 35
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
Image of page 36

Info iconThis preview has intentionally blurred sections. Sign up to view the full version.

View Full Document Right Arrow Icon
Image of page 37
This is the end of the preview. Sign up to access the rest of the document.

{[ snackBarMessage ]}

What students are saying

  • Left Quote Icon

    As a current student on this bumpy collegiate pathway, I stumbled upon Course Hero, where I can find study resources for nearly all my courses, get online help from tutors 24/7, and even share my old projects, papers, and lecture notes with other students.

    Student Picture

    Kiran Temple University Fox School of Business ‘17, Course Hero Intern

  • Left Quote Icon

    I cannot even describe how much Course Hero helped me this summer. It’s truly become something I can always rely on and help me. In the end, I was not only able to survive summer classes, but I was able to thrive thanks to Course Hero.

    Student Picture

    Dana University of Pennsylvania ‘17, Course Hero Intern

  • Left Quote Icon

    The ability to access any university’s resources through Course Hero proved invaluable in my case. I was behind on Tulane coursework and actually used UCLA’s materials to help me move forward and get everything together on time.

    Student Picture

    Jill Tulane University ‘16, Course Hero Intern