Deviations from PPP

1. Deviations from PPP • The LOP would not apply for differentiated products or products that are not traded internationally. • The LOP does not take into account shipping costs or tariffs. • The LOP could hold good for individual goods, but may not hold good if we use price indexes.

2. Deviations from PPP • PPP is an equilibrium relationship between two endogenous variables • Endogenous variable: a variable whose value is determined by some given factors • Exogenous variable: a variable whose value is given to the economic system by an outside force, such as government or nature • Deviations in measured PPP will occur if prices and exchange rates change at different speeds

3. Deviations from PPP • If there is some exogenous shock, changes in exchange rates precede change in prices • Graph illustrating how exchange rate will shift with receiving some economic news • Periods of economic news will be periods when PPP deviations are large, the exchange rate adjusts while prices lag behind • Also, periods dominated by news are likely to be periods involving relative price change

4. Shifts in the foreign-exchange market and deviations ¥/$ S0 S1 A PJA/PUS=140 120 B D’ D $0 $1 $

5. Deviations from PPP • Another reason of deviations from PPP is because international trade involves lag between order and delivery. • Exchange rates are very difficult to forecast • Example: In September US importer agrees to buy books from UK for £1 per book. When contract was signed, books in US sell for $2 and current exchange rate E$/£=2. LOP holds here. This contract calls for delivery and payment in December of £1 per book and US importer expects exchange rate and prices to be unchanged, he expects PPP to hold at the time of payment. On December exchange rate is £1=$1.50.

6. Deviations from PPP • An economist using LOP would compare prices of £1 and $2 with E$/£=$1.50, but $1.50 ≠ 2/1 • Economist’s conclusion that there are important deviations from PPP • These deviations are spurious ( not genuine relationship) • We generate appearance of PPP deviations by comparing exchange rates today with prices that were set in the past

7. “Overvalued” and “Undervalued” Currency • Overvalued currency: Currency worth more than PPP exchange rate. • Undervalued currency: Currency worth less than PPP exchange rate. • Currencies are said to be overvalued if they appreciated more than the difference between the domestic and foreign inflation rates

8. “Overvalued” and “Undervalued” Currency • Overvalued dollar: foreign-exchange value of the dollar appeared to be too high relative to the inflation differentials between US and other developed countries • “Overvalued” currency means: exchange rate is not where it should be; if the free market of supply and demand factors are determining E, then the “overvalued” E is a free market equilibrium rate. This equilibrium is a temporary deviation from PPP • Figure 14.3

9. “Overvalued” and “Undervalued” Currency • “Overvalued” dollar is hurting export-oriented industries • This problem was made visible by large balance-of-payments deficit

10. “Overvalued” and “Undervalued” Currency • Lower labor productivity in developing countries could contribute to the appearance of overvalued currencies • Productivity and PPP were studied by Balassa and Samuelson, 1960

11. Real Exchange Rates • Nominal exchange rate is the exchange rate that is actually observed on the foreign-exchange market • Real exchange rate is actually measured as: Ereal= E/(P/PF), or the nominal exchange rate adjusted for the ratio of home price level relative to the price level abroad • If absolute PPP always held, then the real exchange rate would equal 1