Exchange Rate Economics: Theories and Evidence

3 The economics of the
PPP puzzle
In this chapter we consider some economic explanations for the PPP puzzle,
introduced in the previous chapter. As we shall see,these explanations may be categorised
in terms of the real exchange rate decomposition introduced in Chapter 2,
as equation (2.12),and repeated here:
q t = qt T NT ,T
+ qt .
The first explanation we consider focuses on qt
T and concerns the importance
of transaction costs in driving a wedge between the home price of good i and
its foreign price equivalent. As we saw in Chapter 2 the existence of such
costs can create a neutral band within which it is not profitable to exploit
deviations from the LOOP. Here the main focus is on the role of transaction
costs in creating a non-linear adjustment process for the real exchange rate
and the role this,in turn,can have in explaining the PPP puzzle. Section 3.2
contains a discussion of the well-known Balassa–Samuelson hypothesis and its
explanation for systematic movements in real exchange rates. As we shall
see,this explanation focuses on systematic movements on the relative internal
price ratio, qt
,as the key determinant of systematic movements in
NT ,T
real exchange rates. Finally,in Section 3.3,we consider a number of explanations
related to the role of market structure in explaining the PPP puzzle.
These explanations again focus on the term qt T . The first of these is the issue
of pricing to market and the associated concept of pass-through. Pricing to
market is considered from both a theoretical and empirical perspective. A second
aspect of market structure we consider is the role a country’s distribution
sector (i.e the wholesale and retail trade) can play in explaining systematic movements
of the real exchange rate. That the distribution sector is an important
aspect of market structure in most countries is evidenced by the fact that it
accounts for approximately 20% of value added and employment of developed
countries and often accounts for a much larger proportion of the final
price of goods (as much as 40% in many countries – see MacDonald and
Ricci 2001).