Causes of deviations from PPP

Section 3.4 has shown that there can be substantial and prolonged periods of deviation from relative PPP exchange rates. To understand some of the potential causes for these deviations, it is most fruitful to take a closer look at the more important of the many assumptions we had to make before we could invoke the Law of One Price for individual goods on which PPP is based, see section 3.2.

Transaction costs. An obvious reason for a failure of the Law of One Price is the existence of transaction costs, including shipping costs, insurance costs, tariffs and non-tariff barriers, etc. Any such transaction costs will impose a band width around the Law of One Price rates within which arbitrage is not profitable. Only substantial deviations of the exchange rate enable agents to benefit from arbitrage opportunities. Acknowledging that the band width will vary from one good to another, this suggest that the arbitrage forces will gradually become stronger as the deviation of the exchange rate from PPP increases. One measure for the extent of these types of transaction costs is the deviation between cost, insurance, and freight (CIF) and free on board (FOB) quotations of trade, see Box 14.1 for a further discussion.

Differentiated goods. In deriving the Law of One Price, we assumed we were dealing with homogenous goods. In practice, very few goods are perfectly homogenous. Wines differ not only from one country to another, but even per region and vineyard, a Toyota differs from a Mercedes, there are many different varieties of tulips, etc. In fact, the more knowledgeable you are about specific commodities, the better you usually realize that these are differentiated products, even for such basic items as types of flour, qualities of oil, or grades of iron ore. Since we lump all these different goods together under one heading when constructing our price indices, it is no surprise that absolute PPP does not hold, nor that there can be prolonged deviations of relative PPP. Nonetheless, the various types of differentiated goods are to some extent substitutes for one another. Again, this implies that the arbitrage forces will gradually become stronger as the deviation of the exchange rate from PPP increases.

Fixed investments and thresholds. Before one can take advantage of arbitrage opportunities, economic agents usually have to incur a fixed investment cost to do so, such as establishing reliable contacts, organize shipping and handling, have a distribution and service network, etc. Based on earlier work of the theory of investment under uncertainty, Dixit (1989) and Dumas (1992) therefore argue that in addition to the transaction costs imposing a band width, the sunk cost of investment associated with engaging in arbitrage ensures that traders wait until sufficiently large opportunities open up before entering the market. As Sarno and Taylor (2002, p. 56) put it: “Intuitively, arbitrage will be heavy once it is profitable enough to outweigh the initial fixed cost, but will stop short of returning the real rate to the PPP level because of the .. arbitrage (CvM:

i.e. transaction) costs.” Since the investment costs will vary for different types of goods, this yet again implies that the arbitrage forces will gradually become stronger as the deviation of the exchange rate from PPP increases.

Non-traded goods. When invoking the Law of One Price to derive PPP, we implicitly assumed that all goods entering the construction of the price index were tradable. In fact, a large share of our income, perhaps as much as 60-70 per cent, is spent on non-tradable goods, that is on products or (more frequently) services that effectively cannot be traded

between countries and for which arbitrage, which drives PPP, is not possible. Important examples are housing services, recreational activities, health care services, etc. Although one could argue that the existence of non-tradable goods is just an extreme (namely infinite) case of transaction costs, there is a long tradition in international economics to devote special attention to the distinction between tradable and non-tradable goods, and for good reasons. These issues, and the degree to which non-tradable goods introduce a bias in PPP deviations, are therefore discussed separately in section 3.7 below.

Composition issues. Related to the above point is the observation that in deriving the PPP exchange rate in section 3.2, we assumed that the price indices in the two countries are constructed in an identical way. In practice, this is not the case. Not only do the weights for different categories differ per country, but also the types of goods associated with each category. Obviously, these construction differences can cause deviations from PPP, even when the absolute Law of One Price holds for every individual good. When dealing with many countries, as is the case when we calculate real effective exchange rates, these problems are exacerbated.

Box 3.3 Exchange rates, and prices under hyperinflation

The case of Bolivian hyperinflation in 1984 and 1985 already discussed in Box 19.3 also provides a good test for the validity of PPP under extreme circumstances. The monthly Bolivian inflation rate peaked at 183 per cent (from January to February in 1985). At the same time, the exchange rate of foreign currencies measured in Bolivian pesos (the price of foreign currencies) increased very rapidly. The monthly increase in the price of the US dollar, for example, peaked at 198 per cent (from December 1984 to January 1985).

Obviously, with such high inflation rates, which dwarf the importance of the foreign inflation rates (in this case in the USA), we expect (on the basis of PPP) that changes in the exchange rate are dominated by changes in the Bolivian price level, see equation (3.4). In fact, this is what happened: from April 1984 to July 1985, Bolivian prices increased 230-fold, while in that same period, the US dollar exchange rate increased 247-fold. Figure 3.9 uses a logarithmic graph of the exchange rate and the price level in this period to illustrate this. The slope of the price level curve therefore represent the inflation

rate and the slope of the exchange rate curve the growth rate of the price increase of the US dollar. The similarities in the two curves, and therefore the suggested validity of long-run PPP, are obvious. See Box 19.3 for further details. Moreover, see Figure 3.2 for Bolivia’s performance on exchange rates and prices in the period 1960-2001.

Figure 3.9 Exchange and prices under extreme circumstances Bolivia; exchange rate (pesos per US dollar) and price level (index, 1982 = 1), logarithmic scale

10 100 1,000 10,000 100,000 1,000,000 10,000,000

Jan-84 Apr-84 Aug-84 Nov-84 Feb-85 Jun-85 Sep-85 Dec-85 exchange rate

price level

Calculations based on Morales (1988, Table 7A1).