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Purchasing power parity and exchange rate problems introduction
Journal of kternational Economics 8 (1978) 157461. 0 North-Holland Publishing Company
PURCHASING
POWER PARITY AND EXCHANGE RATE PROJ%EMS INTRODUCT3ON Rudiger DORNBUSCH M.I.T., Cambrk?c&J.MA 02139, U.S.A.
Dwight JAFFEE Princeton University, Prirtcc:ton, NJ 08540, U.S.A.
December 1977
This issue brings together a collection of papers on exchange rates and purchasing power parity (PPP) initially presented at a conference sponsored by the Ford Foundation and the Bank of Greece. The unifying theme of the collection is the relationship between relative price levels and the ex$:hange rates. These relationships spread over quite a range of topics, from empir.‘cal tests of a narrow, monetarist construction, to a broad based consideration of PPP as a guide for exchange rate management and currency areas. The diversity ‘of these topics illustrates well both the central role of PPP in reIation to exchange rate problems, and, perhaps even more fundamentally, the fact that after all is said, PPP has about the same degree of empirical support and policy relevtince as the quantity theory of money. The papers presented here explore several strands of the ongoing discussion of PPP. At the cozt of some simplification, there are two basic views represented here, by Frenkel on one side, and Kravis and Lipsey on tb.e other. The Frenkel paper takes the view that relative real price levels are invariant and that movements in domestic currency price levels are fuQ offset by movements in the exchange rate. The implicit hypothesis is that price movements are generated by monetary disturbances, and that monetary disturbances are neutr”u2with respect to the real economy. The hypothesis in this sharp form obviousl,y stands in conflict with much of the theoretica fiterature, in particular \rfith the seminal papera by Balassa (1964) and Samuelson (1964). These papers, it. will be remembered, argued that differential sectoral rates of productivity growth change real costs and relative prices, and therefore bring about divergent movements in exchange-rate-adjusted national price levels. The relative price level is high in
R. Dorubusch and D. Jaffee, PPP: Introduction
158
high real income countries coImpared with poor countries, and it rises r.lpidly in fast-growing countries compared with slow-growing countries.’
There is a further departure from strict PPP for whi’ch empirical relevance is claimed. This view places emphasis on an intermediate run, as compared to the Balassa-Samuelson secular hypothesis, and argues that exchange rate movements exert real effects because movements in prices and exchange rates are not synchroniscd. Exchan, -ar_ rate movements change relative prices, and these changes, while perhaps only transitory, persist sufficiently lung to provide an (effective policy instrument. The view is basically empirical and eclectic and has not yet shcwn the sources of the differential spee:ds of adjustment of prices. It simply no:es the fact of protracted de\ Iations from ‘the law of one price’ and paints to these deviations as an essential element in the adjustment process. The Kravis and Eipsey paper strongly endorses this view and supports it with ample evidence, as does the Genberg paper. The asset market view of exchange rates, set out ;in the Mundell-Fleming moldel and in subsequent expectations-oriented extensior s, views exchange rates as !~:t in short-run financial markets .2 It plays on the differential speeds of adjustment of prices’ and exchange rates and derives its force in explaining exc:hange rate volatility precisely from deviations fro;m PPP. It is thus firmly based in the camp tbat takes PPP to be, if anything, thtb long-run trend (or at least ‘to be decidedly not sclort-run behavior) of excha:nge rates and prices. Against this background of themes the papers in this issue evaluate theories and evidence ard their relevance for policy. The contribution by Kalamotousakis reviews the historical background, pointing to such early contributions as Wh.eaLtley’s, and pursues that intellectual tradition to the work of Zolotas. ,410cg with the conventional monetarist interpretation of exchange rates he notes the ‘qualitative factors’ which we can safely call an asset market view. The paper by Frcnkel also provides an historical review. It proceeds from there to tests of a narrow monetarist construction of .PPP by trying the hypothelsis that key exchange rates in the 1920s moved in ;Lway that fuZZj$offset divjergent trends in national price levels. The tests yil:ld surprisingly strong support for that hyplothesis, in that one cannot reject r;he hypothesis that in an exchange rate regression, national price levels have co&lcients of unity with opposite signs. In th.is work, much as in work on hyperinflntion, there remains the reservation that the tests do not have enough power to rule out moderate changes in relative prices as required to awommodat:e real disturbances or secular trends. Frenkel follows up his exchange rate tests with price equations. These tests, in an interesting extension of the literature, show that bo;h current and anticipated exchange rates as measured by the forward rate influence cur rent prices. ‘For a review of the literature, see L. Officel (1976). See also McKinnon (1973). 2For a brief review see W. Branson (1975). See also the collccti;)? of papers in the Swedish Journalof Economics
2. 19’76.
R. Dornbusch and D. Jafee, PZ’P: Zntroduction
159
The Kravis and Lipsey paper brings together a long and important I esearch effort on international price relationships. The organizing framewark is a challenge to the monetarist approach, an approach construed to argue that exchange rate movements do not have persistent effects on relative prices, and that international price relationships are very tight in obeying the Iaw of one price. The evidence presented leaves that hypothesis rather in shambles. Real price levels - that is, exchange-rate-adjusted national price levels - are shown to obey the Balassa-Samuelson law. Furthermore, significant changes in exchange rates in the postwar period are shown, invariably, to ai3ect relative prices for periods of several years. At a more disaggregated level, Kravis and Lipsey show divergences in the prices of close to identical traded goods and divergences in the prices of exportables in both the home goods market :znd the world market. This line of research is particularly important because the quality of the data assembled makes them much su&erior to the conventional analysis that uses broad price indices or, even worse, as the authors would say, unit values. The Kravis-Lipsey paper points to international price formation as a major unresolved issue in macroeconomic dynamics and industrial organization. Genbzrg’s paper straddles both the Frenkel and Kravis-Lips,ey approaches. The paper considers the important :ssue of the adjustment process that: brings about the tendency toward PPP and investigates the tightness of’ PPP relations, the average lag in the adjustment process, and trend deviations due to structural change Among the interesting findi*rgs of the Genberg paper we note here the fact that deviations from PPP have become larger in the floating rate period of the 197Os, compared to the tied rate period. While Genber,; notes that exchange rates tend not to be far off their PPP levels once an aC3.,ustmentfor structural change is allowed, he draws attention to the problems for 1xciage rate target design that are posed by the identification of the true bias. The policy perspective on PPP and exchange rates is addressed in the paper by Artus. He develops three approaches to exchange rates. One approach is the asset market view. Under conditions ‘ofperfect capital mobility and full interest arbitrage, the spot rate is determined1 by interest differentials and the exp66ted exchange rates :
where e and Z are the current and the expected exchange rates 2nd d is the interest differential. The spot rate is dominated by s;zpectations about the future course of the exchange rate; indeed, it quite literally discounts that inforrr:ation at a rate equal to the interest differential. Arcus notes the problem in identifying the factors that dominate exchange rate expe:tations and points out the potential volatility of the spot rate that arises if ex6~a~ge rate expectations thems+es
160
R. Dornbusch and D. Jaffee, PPP: .%trotLction
have a high elasticity with resnect to the spot rate. DifIus!: expectations in such a circumstance make a case for exchange rate intervent:ior,. A second approach, based on PPP, considers the real effects ofexchan,ge rates: on competitiveness as measured by relative wholesale prices of manufactures and relative unit labor costs. The data presented here lend support to a tendency toward PPP but, interestingly, do not suggest a loss Iof competitiveness of the U.S. in the late 1960s. A third approach considers exchange rate targets in the framework of I rade balance adjustment to their full employment constellation. Estimates of the constellation of full employment trade balances for the main industrialized countries are presented but the link between these policy targets and exchange rate paths in the adjustment process appears as a complicated issue cdlhng for a d&ailed structural model. The policy problem is thus quite far from PPP, and closer to macroeconomic adjustment and the adjustment of trade flows to changes in real prices. The Thygesen and Vaubel papers approach the question of PPP in the context of European monetary integration. Thygesen discusses the Optiea report, a proposal by a group of experts for the EEC to use PPP as a guideline for exchange rate intervention. The case for a PPP rule is argued on the grounds that real exchange ra?e stability is an important part of macroeconomic stabilization and that PPP-oriented intervention policy contributes to avoiding virtuous and vicious cycles. The choice of an exchange rate intervention strategy to harmonize and stabilize inflation patterns rests on the evidence, detailed in the papers, that within the EEC, exchange rate movements have primarily served to offset inflation. differentials rather than exerting important effects on macroectinomic adjustment. Vaubel’s study addresses real exchange rate variability in the EEC from a perspective of optimum currency area design. Currency areas forego the use of exchange rate realignments. The importance of such adjustments is judged by the historical experience of the EEC. Intercountry variations and real exchange rate variations are smallir than nominal ra.te movements. Exchange rate illusion, it is argued, is a perishabie, no+,. a duralble, good. The failure of the EEC to achieve monetary integration, Vaubel shows, is not dut? to the dominance of external disturbances that necessitate increased real exchange rate flexibility, but rather to a lack of a workable strategy, The paper concludes with a design of an optimum currency area within the EEC, and the distribution of costs and benefits for alternative compositions. The group of papers brought together in this issue :;hares the common focus of exchange rates and relative prices in their role in thle macroeconomic adjustment process. In their variety, they show that PP‘P has moved from a narrow assertion about the behavior of prices and exchange rates to policy-oriented questions of intervention strategies and formation of currency blocks. This shift. of emphasis is !.he focus of current research on A paper by J. David Richardson, which bears on the purchasing power Iarity
issue, is included in the axtainly adds to the evi
sium. While it was mt hera
rt of the 62mIkwnw it
PURCHASING
POWER PARITY AND EXCHANGE RATE PROJ%EMS INTRODUCT3ON Rudiger DORNBUSCH M.I.T., Cambrk?c&J.MA 02139, U.S.A.
Dwight JAFFEE Princeton University, Prirtcc:ton, NJ 08540, U.S.A.
December 1977
This issue brings together a collection of papers on exchange rates and purchasing power parity (PPP) initially presented at a conference sponsored by the Ford Foundation and the Bank of Greece. The unifying theme of the collection is the relationship between relative price levels and the ex$:hange rates. These relationships spread over quite a range of topics, from empir.‘cal tests of a narrow, monetarist construction, to a broad based consideration of PPP as a guide for exchange rate management and currency areas. The diversity ‘of these topics illustrates well both the central role of PPP in reIation to exchange rate problems, and, perhaps even more fundamentally, the fact that after all is said, PPP has about the same degree of empirical support and policy relevtince as the quantity theory of money. The papers presented here explore several strands of the ongoing discussion of PPP. At the cozt of some simplification, there are two basic views represented here, by Frenkel on one side, and Kravis and Lipsey on tb.e other. The Frenkel paper takes the view that relative real price levels are invariant and that movements in domestic currency price levels are fuQ offset by movements in the exchange rate. The implicit hypothesis is that price movements are generated by monetary disturbances, and that monetary disturbances are neutr”u2with respect to the real economy. The hypothesis in this sharp form obviousl,y stands in conflict with much of the theoretica fiterature, in particular \rfith the seminal papera by Balassa (1964) and Samuelson (1964). These papers, it. will be remembered, argued that differential sectoral rates of productivity growth change real costs and relative prices, and therefore bring about divergent movements in exchange-rate-adjusted national price levels. The relative price level is high in
R. Dorubusch and D. Jaffee, PPP: Introduction
158
high real income countries coImpared with poor countries, and it rises r.lpidly in fast-growing countries compared with slow-growing countries.’
There is a further departure from strict PPP for whi’ch empirical relevance is claimed. This view places emphasis on an intermediate run, as compared to the Balassa-Samuelson secular hypothesis, and argues that exchange rate movements exert real effects because movements in prices and exchange rates are not synchroniscd. Exchan, -ar_ rate movements change relative prices, and these changes, while perhaps only transitory, persist sufficiently lung to provide an (effective policy instrument. The view is basically empirical and eclectic and has not yet shcwn the sources of the differential spee:ds of adjustment of prices. It simply no:es the fact of protracted de\ Iations from ‘the law of one price’ and paints to these deviations as an essential element in the adjustment process. The Kravis and Eipsey paper strongly endorses this view and supports it with ample evidence, as does the Genberg paper. The asset market view of exchange rates, set out ;in the Mundell-Fleming moldel and in subsequent expectations-oriented extensior s, views exchange rates as !~:t in short-run financial markets .2 It plays on the differential speeds of adjustment of prices’ and exchange rates and derives its force in explaining exc:hange rate volatility precisely from deviations fro;m PPP. It is thus firmly based in the camp tbat takes PPP to be, if anything, thtb long-run trend (or at least ‘to be decidedly not sclort-run behavior) of excha:nge rates and prices. Against this background of themes the papers in this issue evaluate theories and evidence ard their relevance for policy. The contribution by Kalamotousakis reviews the historical background, pointing to such early contributions as Wh.eaLtley’s, and pursues that intellectual tradition to the work of Zolotas. ,410cg with the conventional monetarist interpretation of exchange rates he notes the ‘qualitative factors’ which we can safely call an asset market view. The paper by Frcnkel also provides an historical review. It proceeds from there to tests of a narrow monetarist construction of .PPP by trying the hypothelsis that key exchange rates in the 1920s moved in ;Lway that fuZZj$offset divjergent trends in national price levels. The tests yil:ld surprisingly strong support for that hyplothesis, in that one cannot reject r;he hypothesis that in an exchange rate regression, national price levels have co&lcients of unity with opposite signs. In th.is work, much as in work on hyperinflntion, there remains the reservation that the tests do not have enough power to rule out moderate changes in relative prices as required to awommodat:e real disturbances or secular trends. Frenkel follows up his exchange rate tests with price equations. These tests, in an interesting extension of the literature, show that bo;h current and anticipated exchange rates as measured by the forward rate influence cur rent prices. ‘For a review of the literature, see L. Officel (1976). See also McKinnon (1973). 2For a brief review see W. Branson (1975). See also the collccti;)? of papers in the Swedish Journalof Economics
2. 19’76.
R. Dornbusch and D. Jafee, PZ’P: Zntroduction
159
The Kravis and Lipsey paper brings together a long and important I esearch effort on international price relationships. The organizing framewark is a challenge to the monetarist approach, an approach construed to argue that exchange rate movements do not have persistent effects on relative prices, and that international price relationships are very tight in obeying the Iaw of one price. The evidence presented leaves that hypothesis rather in shambles. Real price levels - that is, exchange-rate-adjusted national price levels - are shown to obey the Balassa-Samuelson law. Furthermore, significant changes in exchange rates in the postwar period are shown, invariably, to ai3ect relative prices for periods of several years. At a more disaggregated level, Kravis and Lipsey show divergences in the prices of close to identical traded goods and divergences in the prices of exportables in both the home goods market :znd the world market. This line of research is particularly important because the quality of the data assembled makes them much su&erior to the conventional analysis that uses broad price indices or, even worse, as the authors would say, unit values. The Kravis-Lipsey paper points to international price formation as a major unresolved issue in macroeconomic dynamics and industrial organization. Genbzrg’s paper straddles both the Frenkel and Kravis-Lips,ey approaches. The paper considers the important :ssue of the adjustment process that: brings about the tendency toward PPP and investigates the tightness of’ PPP relations, the average lag in the adjustment process, and trend deviations due to structural change Among the interesting findi*rgs of the Genberg paper we note here the fact that deviations from PPP have become larger in the floating rate period of the 197Os, compared to the tied rate period. While Genber,; notes that exchange rates tend not to be far off their PPP levels once an aC3.,ustmentfor structural change is allowed, he draws attention to the problems for 1xciage rate target design that are posed by the identification of the true bias. The policy perspective on PPP and exchange rates is addressed in the paper by Artus. He develops three approaches to exchange rates. One approach is the asset market view. Under conditions ‘ofperfect capital mobility and full interest arbitrage, the spot rate is determined1 by interest differentials and the exp66ted exchange rates :
where e and Z are the current and the expected exchange rates 2nd d is the interest differential. The spot rate is dominated by s;zpectations about the future course of the exchange rate; indeed, it quite literally discounts that inforrr:ation at a rate equal to the interest differential. Arcus notes the problem in identifying the factors that dominate exchange rate expe:tations and points out the potential volatility of the spot rate that arises if ex6~a~ge rate expectations thems+es
160
R. Dornbusch and D. Jaffee, PPP: .%trotLction
have a high elasticity with resnect to the spot rate. DifIus!: expectations in such a circumstance make a case for exchange rate intervent:ior,. A second approach, based on PPP, considers the real effects ofexchan,ge rates: on competitiveness as measured by relative wholesale prices of manufactures and relative unit labor costs. The data presented here lend support to a tendency toward PPP but, interestingly, do not suggest a loss Iof competitiveness of the U.S. in the late 1960s. A third approach considers exchange rate targets in the framework of I rade balance adjustment to their full employment constellation. Estimates of the constellation of full employment trade balances for the main industrialized countries are presented but the link between these policy targets and exchange rate paths in the adjustment process appears as a complicated issue cdlhng for a d&ailed structural model. The policy problem is thus quite far from PPP, and closer to macroeconomic adjustment and the adjustment of trade flows to changes in real prices. The Thygesen and Vaubel papers approach the question of PPP in the context of European monetary integration. Thygesen discusses the Optiea report, a proposal by a group of experts for the EEC to use PPP as a guideline for exchange rate intervention. The case for a PPP rule is argued on the grounds that real exchange ra?e stability is an important part of macroeconomic stabilization and that PPP-oriented intervention policy contributes to avoiding virtuous and vicious cycles. The choice of an exchange rate intervention strategy to harmonize and stabilize inflation patterns rests on the evidence, detailed in the papers, that within the EEC, exchange rate movements have primarily served to offset inflation. differentials rather than exerting important effects on macroectinomic adjustment. Vaubel’s study addresses real exchange rate variability in the EEC from a perspective of optimum currency area design. Currency areas forego the use of exchange rate realignments. The importance of such adjustments is judged by the historical experience of the EEC. Intercountry variations and real exchange rate variations are smallir than nominal ra.te movements. Exchange rate illusion, it is argued, is a perishabie, no+,. a duralble, good. The failure of the EEC to achieve monetary integration, Vaubel shows, is not dut? to the dominance of external disturbances that necessitate increased real exchange rate flexibility, but rather to a lack of a workable strategy, The paper concludes with a design of an optimum currency area within the EEC, and the distribution of costs and benefits for alternative compositions. The group of papers brought together in this issue :;hares the common focus of exchange rates and relative prices in their role in thle macroeconomic adjustment process. In their variety, they show that PP‘P has moved from a narrow assertion about the behavior of prices and exchange rates to policy-oriented questions of intervention strategies and formation of currency blocks. This shift. of emphasis is !.he focus of current research on A paper by J. David Richardson, which bears on the purchasing power Iarity
issue, is included in the axtainly adds to the evi
sium. While it was mt hera
rt of the 62mIkwnw it