LOGO Chapter PRICES IN THE OPEN ECONOMY: PURCHASING POWER PARITY GVHD: PGS.TS Nguyễn Khắc Quốc Bảo Nhóm HVTH: • • Tô Thị Phương Thảo Nguyễn Hoàng Minh Huy Gustav Cassel www.themegallery.com The law of one price in the open economy • A digression on price indices • Purchasing power parity • Purchasing power parity – the facts at a glance • Purchasing power parity extensions • Empirical research • Conclusions • Contents The law of one price in the domestic economy  In the context of the domestic economy, the law of one price states simply that: If two goods are identical, they must sell for the same price The law of one price in the domestic economy  Example • Imagine that Michael Jackson is giving a concert at Wembley Stadium in London, a fortnight from now • All the tickets have been sold at face value through the usual distribution channels across the UK • but excess demand has created a black market The law of one price in the domestic economy  Example BIRMINGHAM £50 ? The law of one price in the domestic economy  Example £50 £ 45 • there are people who make a living out of exploiting just such situations • buy up as many tickets as they could in the cheap location (Manchester) and sell them immediately in the dear location (Birmingham) • making a tidy profit for themselves, driving up the price of tickets in Manchester from £45 and driving down the price in Birmingham from £50 £ 47 The law of one price in the domestic economy  Example • People who make a living by trading rock concert (or football match) tickets on the black market are usually called ‘touts’ or ‘scalpers’ Arbitrage is the process of buying or selling something in order to exploit a price differential so as to make a riskless profit The law of one price in the domestic economy  Example • Given the existence of arbitrageurs, are there any factors that could prevent the law of one price prevailing?   Lack of information x The actual cost of trading: a few trips between the two cities, the price of a small advertisement, some longdistance phone calls, some postage, a few drinks to close valuable deals and oil the wheels, … x Transaction costs are all the costs associated with a transaction, over and above the cost of the item that actually changes hands The law of one price in the domestic economy  Example • As a specialist trader in large blocks, the scalper’s transaction costs are minimal Purchasing power parity extensions   Trade costs: iceberg model Assuming importers pay for transportation, insurance, wastage etc a possible formulation is the so-called iceberg model, which assumes that a proportion τ of every unit of goods shipped internationally is ‘lost’ or consumed in the form of shipping costs, so that the importer only receives the remaining - τ that survives the  voyage If its price in its country of origin is P*F and its price at home is PF, then the two prices will be related as follows: PF = P*F /(1 -τ) (2.10) www.themegallery.com Purchasing power parity extensions  Trade costs: iceberg model The cost of transporting Camembert to Greece involves a similar degree of wastage, then its price will be lower in France than in Greece by 25%, i.e.: PC = (1 -τ) P*C (2.11) So a kilo of Camembert will cost only 75% as much in France as in Greece www.themegallery.com Purchasing power parity extensions  Trade costs: iceberg model • The price of feta relative to Camembert The mechanism just described plainly drives a wedge between the relative prices of the two cheeses in France and Greece From the ratio of Equations 2.10 and 2.11, we can see that:   • So, relative to feta, Camembert will be only 56% as expensive in France as in Greece www.themegallery.com Purchasing power parity extensions  Trade costs: iceberg model  This distortion of relative prices may have far reaching consequences in a number of critical areas of open economy macroeconomics, sufficient to explain some of the apparent anomalies in the pattern of international payments  It is simply worth noting that this is yet another possible explanation for the failure of PPP In this scenario, even if the index weights in the two countries are identical, price levels will still differ, without the fact necessarily representing any www.themegallery.com arbitrage opportunity Incomplete pass-through and pricing to market (PTM) In the last ten years or so, interest in international pricing has broadened out to cover issues related to industrial structure In general terms, the conclusion of this literature is easily stated: exchange rate movements will not necessarily be fully and instantaneously reflected in the prices at which exports are sold in foreign markets Incomplete pass-through and pricing to market (PTM)  Why might there be less than 100% pass-through? To understand what is involved, take the case of an importer buying goods from an exporter, for sale in the importer’s home market Incomplete pass-through and pricing to market (PTM)  Why might there be less than 100% pass-through?  It makes no difference whether the importer is an independent specialist  Whatever the situation, as far as the importer is concerned, exchange rates are a cost just like any other  Viewed from this angle, the question at issue is simply a matter of judging how the typical importer deals with an increase in its costs Incomplete pass-through and pricing to market (PTM)  Why might there be less than 100% pass-through?  Note the obvious point that, even if it is determined to keep its profit margin constant, a firm need only adjust its export price in proportion to the net impact of an exchange rate change  For example, suppose at some point the euro appreciates by 5% against the dollar Incomplete pass-through and pricing to market (PTM)  Why might there be less than 100% pass-through?  In practice there are a number of reasons why firms may be reluctant to adjust export prices even to this extent in the short run   In the first place, exchange rate movements are high-frequency events Moreover, a firm may well have explicit long term contracts to supply products at fixed prices, in which case it must absorb currency volatility in its profit margins unless it has hedged Over and above all these considerations is the cost of actually publicizing price changes – costs of printing, advertising, informing customers and so on Incomplete pass-through and pricing to market (PTM)  Why might there be less than 100% pass-through? In summary, changing prices is an activity that itself involves costs Incomplete pass-through and pricing to market (PTM)  Why might there be less than 100% pass-through?  In addition to these factors, a behavioural explanation for the stickiness of traded goods prices is widely accepted by policymakers and many researchers  For example, suppose the French winegrower has incurred heavy setup costs in establishing a presence in the US market  These costs can be regarded as an irreversible investment whose payoff is the flow of future net profits the firm hopes to earn from US sales  Under these circumstances, the French decide to keep the dollar price of its wine fixed when the euro appreciates company may Incomplete pass-through and pricing to market (PTM)  Why might there be less than 100% pass-through?  All this presupposes that firms are actually able to sustain a policy of price discrimination, at least in the short run  But can firms actually seal off their export market from their domestic market? Can they prevent arbitrage leakage of products from the cheaper to the more expensive market?   Obviously, the answer varies from country to country and from case to case In reality, we observe that the most effective barriers to prevent agents from exploiting deviations from the law of one price are invariably created by governments for one reason or another  Again, the question can only be answered by empirical research Empirical research  Through the 1970s and 1980s, the emerging consensus based on univariate regressions seemed to point to the gloomy conclusion that, even in tlong run, he there was no evidence to support PPP On the contrary, the real exchange rate appeared to be what statisticians call a random walk, in other words, a process that only changes as a result of purely random disturbances: qt = qt−1 + ut Ut is a zero-mean random shock unrelated to any previous history www.themegallery.com Empirical research  The new approaches to PPP have also served to refocus attention of the research community on the law of one price Isard (1977) had found evidence of substantial deviations on the basis of regression tests of an equation based on Equation 2.3: p* i + s = a + bpi + u  If the law of one price works as expected, the intercept, a, should be zero and the gradient, b, should be insignificantly different from 1.0 Instead, it turned out that, in most cases, these conditions were clearly not satisfied  The authors found vastly greater international failures in LoP, which they summarized in the dramatic finding that an international border has the same effect as would an additional 75,000 miles between cities in the same www.themegallery.com country LOGO Thank You! ... www.themegallery.com The law of one price in the open economy • A digression on price indices • Purchasing power parity • Purchasing power parity – the facts at a glance • Purchasing power parity. .. price in the domestic economy  Example The interaction of normal traders – fans wanting to attend the concert and the organizers supplying the seats – these are the ultimate determinants of the. .. selling their tickets in Birmingham almost at the same time that they buy in Manchester, so that their actual trading risk is zero The absence of risk is a distinguishing feature of arbitrage The