Slide 2.

Chapter 2

Prices in the Open Economy:

Purchasing Power Parity

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
 Slide 2.2

2.1 The Law of One Price in the Domestic Economy

The law of one price -
two goods, if they are identical, must sell for the same price.

The law of one price in the context of domestic economy

the relationship holds if transaction costs are allowed: e.g.,

PB = PM + C (2.1)
where
PB,PM - the price of a ticket in Birmingham and Manchester respectively;
C - the transaction cost.

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
 Slide 2.3

2.2 The Law of One Price in the Open Economy

The law of one price in the context of open economy

two identical goods must sell for a price that is the same
when translated into a common currency: e.g.,

PL = SPNY + C (2.2)

where
PL, PNY - price in London and New York respectively;
S - price of a dollar;
C - transaction cost.

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
Slide 2.4

2.4 Purchasing Power Parity

From Law of One Price:
P SP(i =* 1, . . ., N) (2.3)
i i

where - Pdomestic
i prices of good number i
*
-P foreign
i prices of good number i*

to PPP:
P SP * (2.4)

where -Phome countrys price index,

- foreign
P* countrys price index.

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
Slide 2.5

Interpretations of PPP
1. price of a basket of goods ought to be the same
everywhere
2. money should buy the same basket of goods
wherever it is spent
3. the exchange rate adjusted for relative prices
should be 1.0

Copeland, Exchange Rates and International Finance, 6th edition

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 Slide 2.6

2.4 Purchasing Power Parity (continued)

Real exchange rate
the price of foreign relative to domestic goods and services; i.e.,

Q SP* / P
(2.5)

where Q
- real exchange rate,
S
- nominal exchange rate,
P* / P
- relative prices (foreign to domestic)

Note: if PPP applies, Q = 1 at all times

Copeland, Exchange Rates and International Finance, 6th edition
Pearson Education Limited 2014
 Slide 2.7

2.4 Purchasing Power Parity (continued)

Taking logarithms on both sides of equation (2.4),

p s p* (2.6)

where p log( P ) , s log( S ) and p log( P )

* *

Differentiating equation (2.6),

dp ds dp* (2.7)
where
dp, dp*- inflation rate of the home country and foreign country respectively;
ds - rate of currency depreciation.
Interpretation: either movements in the exchange rate reflect inflation
differentials or opposite
Copeland, Exchange Rates and International Finance, 6th edition
Pearson Education Limited 2014
Slide 2.8

2.4 Purchasing Power Parity (continued)

Taking transaction costs into account, Eq.(2.4) is modified

P K ( SP* ) (2.4)

where
K - a constant;
- can be greater or less than unity;
- covers the total cost of conducting international trade.

Taking logarithms on both sides of (2.4)

(2.5)
p k s p*

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
Slide 2.9
Figure 2.1 Real Exchange rates 1970 - 2011 (consumer prices)
250 1999 =100

225

British pound
200
French franc (until end-1998)
Swiss franc
Dollar Stronger ----->
Japanese yen
175 German deutschmark (Euro from 1999 onward)

150

125

100

75
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011

Year

Copeland, Exchange Rates and International Finance, 6th edition

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Slide 2.10
Figure 2.2 Real exchange rates 1970 - 2011 (producer prices)
1999 = 100
200

British pound
French franc (until end-1998)
175 Swiss franc
Japanese yen
German deutschmark ( Euro from 1999 onward)

Dollar Stronger ----->

150

125

100

75
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011

Year

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
 Slide 2.11
Figure 2.3 Purchasing power parity exchange rates 1970 - 2011 (consumer prices)
1999 = 100
1000
950
900 British pound
850 French franc (until end-1998)
800 Swiss franc
750 Japanese yen
German deutschmark (Euro from 1999 onward)
700
650
Dollar stronger ----->
600
550
500
450
400
350
300
250
200
150
100
50

Year

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
 Slide 2.12
Figure 2.4 Purchasing power parity exchange rates 1970 - 2011 (producer prices)
1999 = 100
550
520
490 British pound
French franc (until end-1998)
460
Swiss franc
430
Japanese yen
400 German deutschmark (Euro from 1999 onward)
Dollar
370stronger --------->
340
310
280
250
220
190
160
130
100
70
40

Year

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
 Big Mac Index (v $US)
Slide 2.13
January 2014
India
South Africa
Malaysia
Ukraine
Indonesia
Hong Kong
Egypt
Taiw an
Russia
Sri Lanka
China
Mexico
Thailand
Saudi Arabia
Japan
Philippines
Poland
Argentina
Pakistan
UAE
Lithuania
South Korea
Czech Republic
Peru
Singapore
Chile
Turkey
Estonia
Hungary
Portugal
Greece
Costa Rica
Colombia
Australia
New Zealand
Austria
United States
Britain
Netherlands
Ireland
Uruguay
Spain
Euro area
Germany
Canada
Israel
France
Denmark
Italy
Brazil
Belgium
Finland
Sw eden
Sw itzerland
Venezuela
Norw ay
-80.00 -60.00 -40.00 -20.00 0.00 20.00 40.00 60.00 80.00

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
Slide 2.14

2.6.1 Harrod-Balassa-Samuelson
Technology advances less rapidly in service sector than in
goods manufacturing, driving up marginal physical
product of labour (MPPL) in goods relative to service
sectors
Wage = value of MPPL across economy, as competition
operates and labour moves between sectors , so wage =
value of MPPL in goods sector, wage > value of MPPL in
services until service prices rise relative to goods prices
as time passes
Goods (services) mostly (non-) tradeable
Result: richer, more advanced economies look less
competitive in a comparison of real exchange rates based
on general price index
Copeland, Exchange Rates and International Finance, 6th edition
Pearson Education Limited 2014
Slide 2.15

2.6.2 Purchasing Power Parity Extensions

Goods arbitrage only profitable when price deviation
exceeds transactions costs, c, so:
If price deviation < c, no trade
If price deviation > c, trade (in large quantity!)
But c different for each trader and each type of good
So when price deviation large (small), arbitrage (not)
profitable for most traders/goods
In general, larger is price deviation, greater volume of
arbitrage and more rapid is real exchange rate adjustment

Copeland, Exchange Rates and International Finance, 6th edition

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Slide 2.16

qt qt 1 f [(qt 1 qt 1 ), zt 1 ] (qt 1 qt 1 )

where
qt 1- the log of real exchange rate at t-1;
qt 1- its equilibrium level at t-1;
zt - summarizes a list of other factors that may affect q
f - a measure of the extent to which a gap between qt 1
and is eliminated
qt 1 by the next periods change in the
exchange rate 0 < f < 1.

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
Slide 2.17

2.6.3 Trade Costs: Iceberg Model

* /(1 )
PF PF (2.10)

where
PF*- price of a foreign product in its (foreign) country of origin
PF- price of a foreign product imported into home country

- proportion of every unit of goods lost due to shipping

cost (melting iceberg)

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
 Slide 2.18

UK EU

PF* LOST (" melted" )

PF P *
(1 ) fraction F

LOST (" melted" )

PC (1 ) PC*
fraction PC*

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014
Slide 2.19

2.6.3 Trade Costs: Iceberg Model (continued)

PC (1 ) PC* (2.11)

where
PC*- price of a home-produced good in foreign country
-P
price of a home-produced product at home.
C

From the ratio of equations (2.10) and (2.11),

PC / PF (1 ) 2 PC* / P *
(2.12)
F

Copeland, Exchange Rates and International Finance, 6th edition

Pearson Education Limited 2014