Exchange Rate Economics: Theories and Evidence

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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)
44 Purchasing power parity and the PPP puzzle The extreme asset view of PPP advocates the separation of exchange rate determination from traded prices and recommends a focus on non-traded prices: Strictly interpreted then,prices of non-internationally traded commodities only should be included in the indices in which purchasing power pars are based. (Graham 1930) An even more extreme version of this idea advocates the use of wage rate parity, the wage being the price of the least traded commodity (Rueff 1926; Cassel 1930). We now present a definition of what we,and others,refer to as ‘traditional’ PPP. It is fair to say that few proponents of PPP would be wedded to such a strict definition of PPP as given in expressions (2.3) or (2.4). Rather,proponents of PPP such as Gustav Cassel,who is generally regarded as the proponent of the version of PPP discussed here,would argue that absolute PPP is a level to which an exchange rate gravitates,but it can be away from this level for some time,due to factors such as foreign exchange market intervention or non-zero interest differentials (see Officer 1976,for example,for an extended discussion of this issue). One way of capturing this idea is to say that instead of the log of the real exchange rate being equal to zero,as in (2.4 ′ ),it should be mean-reverting: q t = ρq t−1 + β + ε t , 0
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Exchange Rate Economics Exchange Ra
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Firstpublished2007 by Routledge 2Pa
Page 8 and 9: Contents List of figures List of ta
Page 10 and 11: Figures 1.1 The balance of payments
Page 12 and 13: Figures 13.6 Fourth generation spec
Page 14: Preface This book is the second edi
Page 17 and 18: 2 Introduction Although the textboo
Page 19 and 20: 4 Introduction (orders to buy/sell
Page 21 and 22: 6 Introduction Table 1.3 Currency d
Page 23 and 24: 8 Introduction a truly flexible exc
Page 25 and 26: 10 Introduction this has to be sati
Page 27 and 28: 12 Introduction likely that the rel
Page 29 and 30: 14 Introduction or F (1 + i) = S (1
Page 31 and 32: 16 Introduction Consider now a fall
Page 33 and 34: 18 Introduction The empirical evide
Page 35 and 36: 20 Introduction (mean and variance)
Page 37 and 38: 22 Introduction (a) (b) 0.3 0.25 0.
Page 39 and 40: 24 Introduction clusters or that it
Page 41 and 42: 26 Introduction 0.1 0.05 0 -0.05 -0
Page 43 and 44: 28 Introduction 1.9 Exchange rate r
Page 45 and 46: 30 Introduction fixed versus flexib
Page 47 and 48: 32 Introduction influences. For exa
Page 49 and 50: 34 Introduction 1.11 The determinan
Page 51 and 52: 36 Introduction In the standard OCA
Page 53 and 54: 38 Introduction most transactions i
Page 55 and 56: 40 Purchasing power parity and the
Page 57: 42 Purchasing power parity and the
Page 83 and 84: 3 The economics of the PPP puzzle I
Page 85 and 86: 70 The economics of the PPP puzzle
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4 The flexible price monetary appro
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96 The flexible price monetary appr
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98 The flexible price monetary appr
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100 The flexible price monetary app
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5 The sticky-price monetary model I
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108 The sticky-price monetary model
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6 The monetaryapproach to the excha
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136 Empirical evidence on the monet
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Table 6.5 SEM equations: United Kin
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7 Currencysubstitution models and t
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168 Currency substitution and portf
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200 Real exchange rate determinatio
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228 Equilibrium exchange rates rate
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230 Equilibrium exchange rates A nu
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232 Equilibrium exchange rates long
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234 Equilibrium exchange rates 5.1
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236 Equilibrium exchange rates term
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238 Equilibrium exchange rates 0.30
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240 Equilibrium exchange rates Detk
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242 Equilibrium exchange rates US i
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244 Equilibrium exchange rates The
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246 Equilibrium exchange rates 9.6.
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248 Equilibrium exchange rates 9.6.
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250 Equilibrium exchange rates Conc
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252 The new open economy macroecono
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11 The new open economy macroeconom
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290 Target zone models 12.1 The bas
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292 Target zone models stochastic c
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294 Target zone models moves from 2
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296 Target zone models where A 1 an
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298 Target zone models expected dev
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300 Target zone models % expected d
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302 Target zone models MacDonald (2
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304 Target zone models for the DM-l
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306 Target zone models explicit ban
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308 Target zone models Table 12.1 F
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310 Target zone models short-term i
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312 Target zone models the UK short
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314 Speculative attack models and c
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340 Market microstructure approach
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15 Spot and forward exchange rates
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Notes 1 Introduction: some basic co
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398 Notes 4 Although the split betw
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400 Notes 3 The fact that the utili
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402 Notes 15 This result is familia
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404 Notes 6 Where ∫ ∞ vg(v) E(v
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406 References Artis,M. and M. Lewi
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408 References Bergin,P.,R. Glick a
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410 References Calvo,G.A. and C.A.
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412 References Clark,P.B. and R. Ma
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414 References Detken,C.,A. Dieppe,
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416 References Edwards,S. and I. Ma
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418 References Fischer,S. (2001),
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420 References Frieden,J.P.G. and E
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422 References Granger,C.W. and T.
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424 References Hooper,P. and J. Mor
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426 References Kearney,C. and R. Ma
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428 References Lewis,K. (1988),‘T
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430 References MacDonald,R. (2002),
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432 References Mark,N.C. (2001),Int
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434 References Obstfeld,M. and K. R
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436 References Roll,R. (1979),‘Vi
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438 References Tauchen,G.E. and M.
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Index Abadir,K. 389 Abuaf,N. 60 Adl
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442 Index Diba,B. 177-8 Dickey,D.A.
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444 Index Gagnon,J. 212 Gali,J. 128
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446 Index Miller,M.H. 120,123,128,1
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448 Index purchasing power parity (
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450 Index trade: interbank trade 34
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Exchange Rate Economics: Theories and Evidence

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