International macroe.. - Free

7.2. DEVIATIONS FROM THE LAW-OF-ONE PRICE 209typically ask whether q t is stationary about a Þxedmeanbecauseevenif PPP holds, measured q t will be (p 0 − p ∗ 0) which need not be 0 due tothe base year normalization of the price indices.An older literature made the distinction between absolute PPP (s t +p ∗ t − p t = 0) and relative PPP (∆s t + ∆p ∗ t − ∆p t = 0). By taking Þrstdifferences of the observations, the arbitrary base-year price levels dropout under relative PPP. In this chapter, when we talk about PPP, wemean absolute PPP.A second issue that you confront in this line of research is that thereare as many empirical real exchange rates as there are price indices. Asdiscussed in chapter 3.1, you might use the CPI if your main interestis to investigate the Casellian view of PPP because the CPI includesprices of a broad range of both traded and nontraded Þnal goods. ThePPI has a higher traded-goods component than the CPI and is viewedby some as a crude measure of traded-goods prices. If a story aboutaggregate production forms the basis of your investigation, the grossdomestic product deßator may make better sense.7.2 Deviations from the Law-Of-One PriceThe root cause of deviations from PPP must be violations of the law-ofoneprice. Such violations are easy to Þnd. Just check out the price ofunleaded regular gasoline at two gas stations located at different cornersof the same intersection. More puzzling, however, is that internationalviolations of the law-of-one price are several orders of magnitude largerthan intranational violations. There is a large empirical literature thatstudies international violations of the law-of-one price. We will considertwo of the many contributions that have attracted attention ofinternational macroeconomists.Isard’s Study of the Law-Of-One PriceIsard [79] collected unit export and unit import transactions pricesfor the US, Germany, and Japan from 1970 to 1975 at 4 and 5 digitstandard international trade classiÞcation (SITC) levels for machineditems. Isard deÞnes the relative export price to be the ratio of the US