PERSPECTIVES ON PPP AND LONG-RUN REAL EXCHANGE

RATES

Kenneth A. FrootKenneth RogoffNBER 4952A chapter in Handbook of international economics

Contents

Evolving Tests of Simple PPP Definitions and Basic concepts Stage one: Simple PPP as the Null Hypoth

esis Stage Two: The Real Exchange Rate as a

Random Walk Stage-three tests: Cointegration Tests Using Disaggregated Price Data

Contents

Structural Models of Deviations from PPP Productivity, Government Spending and the Rela

tive Price of Non-tradables A Small Country Model of the Balassa-Samuelso

n Effect Long-tern Productivity Differentials and the Real

Exchange Rate Pricing to Market

Simple PPP

Cassel’s(1922)Exchange rate should tend to

equalize relative price levels in different countries

Some alternative definitions

Definitions and Basic Concepts

ttt sipip )(*)(

ttt sCPIpCPIp )(*)(

ttt sCPIpCPIp )(*)(

Relative PPP

If price index movements are dominated by monetary shocks, and if money is neutral in the long run, then it won’t matter if the two baskets being compared are not the same; relative PPP should still hold (approximately).

Stage one:

Frenkel(1978): data on high inflation economies

tttt pps )*(

?1

PPP should be an important building block of any model of exchange rate determination

Stage one:

Frenkel(1981): the failure of PPP might be attributable to some combination of temporary and sticky goods prices, implicitly arguing that PPP still holds in the long run.

Isard(1977) and Giovannini(1988): another problem is that exchange rates and prices are simultaneously determined.

Krugman(1978) and Frenkel(1981): the bias in the key coefficient can be removed by conditioning the regression on the real exogenous factors that affect both exchange rates and prices.

Stage Two: The Real Exchange Rate as Random Walk

The null hypothesis becomes that the real exchange rate follows a random walk, with the alternative hypothesis being that PPP holds in the long run.

tttt ppsq *

The problem of low power: it can be very hard to distinguish between slow mean reversion and a random walk real exchange rate.

Econometric Techniques

D-F, ADF test, Phillips and Perron test

10:

1:

)(

211

20

11210

andH

H

qLqtq tttt

Meese-Rogoff(1988): monthly dollar/pound, dollar/yen, dollar/DM

Econometric Techniques

Variance ratios: under the null hypothesis of a random walk, the variance of the real exchange rate should grow linearly over time.

Fractional integration: ARMA process

Results for Post-Bretton-Woods Data

The basic result in the empirical literature is that if one applies unit roots tests to bilateral industrialized-country monthly data, it is difficult to reject the null of a unit root for currencies that float against each other.

For currency pairs that are fixed ( or formally stabilized), the evidence is more mixed.

The post-Bretton-Woods sample period is far to short to reliably reject the random walk hypothesis.(72 years!)

Test Using Cross Sections of Currencies

Hakkio(1984): Abuaf and Jorion(1990): Cumby(1993): Hamburger Standard, 7 yea

rs and 25 countries The longer time series and the larger cros

s-section does generate more power. Exchange rate regime Hyperinflation Mcdonald’s own pricing policies

Test Using Longer Time Series

Frankel(1986): 116 years(1869-1984) A simple first-order autoregression yields a coeffi

cient of 0.86, which implies that PPP deviations have an annual decay rate of 14 percent and a half life of 4.6 years

Edison(1987) : a half life of roughly 7.3 year Johnson(1990): a half life fro PPP deviations of 3.

1 years Abuaf and Jorion(1990): 3.3 years Lothian and Taylor(1994): dollar-pound(1791-199

0) and franc-pound(1803-1990)

Test Using Longer Time Series

Lothian and Taylor(1994): dollar-pound(1791-1990) and franc-pound(1803-1990)

Using only the post-Bretton-Woods portion of the data, they are not able to reject the random walk hypothesis . But when the entire sample is used, the random walk null is easily rejected for either rate. Moreover, using a simple Chow test, one cannot reject the hypothesis of no structural change.

A Caveat

The countries for which very long-run PPP series are easily available tend to be those few who have continuously been among the world’s wealthiest nations.

Argentine austral against the US dollar and the British pound over period 1913-1988

ADF test

Stage-three tests: Cointegration

Engle and Granger(1987)Some linear combination of exchange

rates and pieces be stationary

ttt pps **

No restrictions on the coefficients

The symmetry restrictions

techniques

Exchange rates and prices~CI(1,1) Three-step procedure One tests the exchange rate and the two domesti

c price series for unit roots The second stage is to estimate the cointegrating

regression using OLS The third step is to use the OLS residuals to run t

he DF regression, but with the time trend omitted

Johansen Test

One-step full-information maximum-likelihood estimator

Horvath and Watson(1993) extend the Johansen methodology to allow for constraints that represent long-run equilibrium conditions

Empirical Results

Rejections of the no-cointegration null occur less frequently for currency pairs that are floating than currency pairs that are fixed

Tests based on CPI price levels tend to reject less frequently than tests based on WPIs

For post-Bretton-Woods floating exchange rates, rejections of the no-cointegration null occur more frequently for trivariate systems than for bivariate systems.

Empirical Results

One possible explanation for the wide-ranging coefficient estimates is small-sample bias.

It can be very difficult to interpret the results of cointegration tests when estimates of the cointegrating vector has no apparent economic meaning.

Kim(1990): during the 1900-1987 period no cointegration!

Tests Using Disaggregated Price Data

The law of one price Isard(1977),Giovanningi(1988) deviations from PPP not only among disaggrega

ted traded goods, but even among basic commodity

Several recent studies: departures from PPP are caused mainly by the presence of nontraded goods versus deviations from the law of one price in traded goods.

Disaggregated Price Data for the Modern Floating Rate Period

Engel (1993): even for apparently homogenous traded goods such as bananas, the deviations from the law of one price can be large and volatiles

Rogers and Jenkins(1993): 81% of the variance in the real CPI exchange rate is explained by changes in the relative price of traded goods.

Engel and Rogers(1994): the variability in prices between two U.S. or two Canadian cities is much less than between a Canadian and a U.S. city.

Prices are sticky in local currency, and that changes in the exchange rate lead to deviations in the law of one price.

Disaggregated Price Data and Longer Times Series Samples

Structural Models of Deviations from PPP

A number of studies that attempt to explain empirically deviations from PPP in terms of more fundamental factors such as productivity, government spending and strategic pricing decisions by firms.

Productivity, Government Spending and the Relative Price of Non-tradables

Balassa(1964) and Samuelson(1964): after adjusting for exchange rate , CPIs in rich countries will be high relative to those in poor countries, and that CPIs in fast-growing countries will rise relative to CPIs in slow-growing countries.

Baumol-Bowen effect: there is a broad tendency for service intensive goods (education, health care, auto repair, banking, etc. ) to rise over time within a country

Long-tern Productivity Differentials and the Real Exchange Rate

Balassa was first to formally test the proposition that richer countries have higher real exchange rates

Summers and Heston(1991): cross-sectional implications

Long-tern Productivity Differentials and the Real Exchange Rate

Hsieh(1982): time series implications Marston(1987) and Edison and Klovan

(1987) Froot and Rogoff(1991a,b) Mendoza(1994) De Gregorio, Giovannini, and Wolf(199

4a)

Demand Factors and the Real Exchange Rate

Demand factors may matter, at least in the short run Froot and Rogogg(1991a): government spending on nontra

ded goods Rogoff(1992): yen/dollar over the period 1975-1990 De Gregorio, Giovannini, and Wolf(1994a): a cross-country

panel regression The find that over the long run, the productivity di

fferentials remain extremely significant whereas the effects of demand factors (government spending and income) become less important.

De Gregorio and Wolf(1994): the TOTs are important empirically

Pricing to Market

Krugman(1987) and Dornbusch(1987) Oligopolistic suppliers Costs are set in nominal terms in the curr

ency of the supplier in the short-run. If there is an exogenous appreciation in the home country’s nominal exchange rate, the markup over cost on foreign goods will fall if the foreign price elasticity of demand is greater than unity.

Pricing to Market

Knetter(1989): PTM is more pronounced for German and Japanese exporters than it is for American exporter.

Ghosh and Walf(1994): discrimination between menu costs and PTM

Feenstra and Kendall(1994) argue that changes in price markups across countries over time may have a permanent component