Exchange Rate Economics: Theories and Evidence

86 The economics of the PPP puzzle
3.4 Market structure and the role of the
distribution sector
As noted in the introduction,the distribution sector plays an important role
in industrial countries where it often reaches 20% of industrial activity both in
terms of value added and of employment and might therefore account for a
large component of prices. For example,using US input–output data,Burstein
et al. (2000) show that consumption goods in the US contain distribution services
accounting for about 47% of the final price in the agricultural sector and 42%
in manufacturing. Dornbusch (1989) mentions the importance of the distribution
sector in influencing the RER via ‘the service content of the consumer prices
of goods’. Recent studies of the Balassa–Samuelson effect,which use sectoral
data to derive measures of relative productivity of tradables and non-tradables,
include the distribution sector in the non-tradable sector (see the discussion above).
Both Devereux (1999) and Burstein et al. (2000) explicitly discuss the role of the
distribution sector in explaining the RER,but still treat the sector as a nontradable
(in both papers it is assumed to influence the domestic consumption
price of tradables,after international price equalization). Obstfeld and Rogoff
(2000) briefly mention,but do not pursue,the role of the distribution sector
as an alternative explanation for the relatively slow mean reversion in RERs.
Engel (1999) has suggested the distribution sector as one explanation for the
variability of the relative price of non-traded goods in explaining US CPI-based
RER movements.
MacDonald and Ricci (2001,2005) empirically examine the role of the distribution
sector on the real exchange rate and,in particular,whether productivity
in the distribution sector influences the real exchange rate through the tradable or
non-tradable channels. In order to motivate their empirical tests MacDonald and
Ricci introduce the distribution sector into a variant of the Balassa–Samuelson
model considered in Section 3.2.1 and we briefly overview their model here. The
model assumes constant returns to labor in all primary activities,that is production
of intermediate inputs (I ),of distribution services (D),of non-tradables goods
(N ) and of the aggregation services (A) necessary to manufacture tradables from
intermediate inputs. 6,7 The technology for secondary activities are Cobb-Douglas:
in goods I , D and A,for the production of tradables (T ); and in goods T and D in
order to make tradables available to consumers (TC). The model is then completed
by assuming different technologies in the primary activities across countries,identical
Cobb-Douglas preferences in tradables and non-tradables across countries,
wage equalisation within countries,international price equalisation for tradables,
and non-tradability of intermediate inputs. In formulas,for country i (i = 1,2):
Y ki = L ki
β ki
, k = I , D, N , A (3.30)
Y γη
Ii
Y 1−γ
Di
Y γ(1−η)
Ai
Y Ti =
(γ η) γη (1 − γ) 1−γ ,(3.31)
(γ (1 − η)) γ(1−η)