Exchange Rate Economics: Theories and Evidence

Purchasing power parity and the PPP puzzle 43
existence of transaction costs can have more complex,non-linear,implications for
the PPP hypothesis and the behaviour of the real exchange rate.
An alternative version of PPP,referred to as relative PPP,is obtained by
expressing the variables in (2.5) in terms of changes:
s t = p t − p ∗ t ,(2.7)
where a denotes a first difference operator. Relative PPP indicates that countries
with relatively high inflation will experience a depreciating currency. Compared
to absolute PPP this variant of PPP is relatively uncontroversial.
A final issue relating to the construction of absolute PPP concerns the assumption
earlier that all goods entering the overall price levels are traded. Few aggregate price
measures include only traded goods and that is especially true of the price measures
many researchers have used to test PPP (which indeed are in index form rather than
levels – we shall return to this point later). The issue of whether a price measure
that includes non-traded goods is suited to a test of PPP has long been debated
in the international finance literature. 4 Frenkel (1976) has a nice discussion of this
issue,and the following few paragraphs draw on his contribution. For example,a
number of the original proponents of APP advocated the use of only traded goods
prices in the computation of PPP (e.g. Pigou 1920; Angell 1922; Viner 1937)
while another group advocated using a price measure that covers a broad range of
commodities,including non-traded goods (see,for example,Hawtrey 1919; Cassel
1928). Frenkel notes that those who advocate a PPP computation based only on
traded goods prices emphasize the role of commodity arbitrage,while an asset
approach to the determination of exchange rates underpins the view of those who
propose a broader price measure (the asset approach is discussed in Chapters 4–7) –
an x per cent rise in the supply of money should lead to an equiproportionate rise
in all prices in an economy,both traded and non-traded (this view is considered in
some detail in Chapter 4). For example,Samuelson (1964) underscores the view
that the equilibrium exchange rate is determined by a spatial arbitrage process
from which non-traded goods are excluded:
Patently,I cannot import cheap Italian haircuts nor can Niagara-Falls
honeymoons be exported.
On the other hand,the asset view of PPP takes it as given that arbitrage forces
the LOOP and argues that if the PPP hypothesis only applies to traded goods then:
The purchasing power parity doctrine presents but little interest ...(it) simply
states that prices in terms of any given currency of the same commodity must be
the same everywhere .... Whereas its essence is the statement that exchange
rates are the index of monetary conditions in the countries concerned.
(Bresciani-Turrono 1934)