DEVIATIONS FROM PPP So far the discussion has included several reasons why deviations from

PPP occur. When discussing the role of arbitrage in goods markets, it was said that the law of one price would not apply to differentiated products or products that are not traded internationally. Furthermore, since international trade involves shipping goods across national borders, prices may differ because of shipping costs or tariffs. Relative price changes can also

be a reason why PPP would hold better in the long run than the short run. Such relative price changes result from real economic events, like changing tastes, bad weather, or government policy. The appendix provides further details on how relative prices can affect the PPP.

Since consumers in different countries consume different goods, price indexes are not directly comparable internationally. We know that evalu- ating PPP between the United States and Japan using the U.S. and Japanese consumer price indexes is weakened by the fact that the typical Japanese consumer buys a different basket of goods than the typical U.S. consumer. In this case, the law of one price could hold perfectly for individual goods, yet we would observe deviations from PPP using the consumer price index for Japan and the United States.

It is important to realize that PPP is not a theory of exchange rate determination. In other words, inflation differentials do not cause exchange rate change. PPP is an equilibrium relationship between two endogenous variables. When we say that prices and exchange rates are endogenous, we mean that they are simultaneously determined by other factors. The other factors are called exogenous variables. Exogenous variables may change independently, as with bad weather or government policy. Given a change in an exogenous variable, as with poor weather and a consequent poor harvest, both prices and exchange rates will

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of monies). We know that exchange rates vary throughout the day as the demand and supply for foreign exchange vary. But how often does the department store change the price of furniture, or how often does the auto parts store change the price of tires? Since the prices that enter into published price indexes are slower to adjust than are exchange rates, it is not surprising that exchange rate changes seem to lead price changes. Yet if exchange rates change faster than goods prices, then we have another reason why PPP should hold better in the long run than in the short run. When economic news is received, both exchange rates and prices may change. For instance, suppose the Federal Reserve announces today that it will promote a 100 percent increase in the U.S. money supply over the next 12 months. Such a change would cause greater inflation because more money in circulation leads to higher prices. The dollar would also fall in value relative to other currencies because the supply of dollars rises relative to the demand.

Following the Fed’s announcement, would you expect goods prices in the United States to rise before the dollar depreciates on the foreign exchange market? While there are some important issues in exchange rate determination that must wait until later chapters, we generally can say here that the dollar would depreciate immediately following the announcement. If traders believe that the dollar will be worth less in the future, they will attempt to sell dollars now, and this selling activity drives down the dollar’s value today. There should be some similar forces at work in the goods market as traders expecting higher prices in the future buy more goods today. But for most goods, the immediate short-run result will be a depletion of inventories at constant prices. Only over time will most goods prices rise.

Figure 7.2 illustrates how the exchange rate will shift with news. The figure illustrates the quantity of dollars bought and sold on the horizontal axis and the yen price of the dollar on the vertical axis. Initially, the foreign

exchange market equilibrium occurs where the demand curve, D 0 , intersects the supply curve, S 0 , at an exchange rate of 120 yen per dollar with quantity $ 0 of dollars being bought and sold. Suppose the Federal Reserve now issues

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Deviations from PPP S 0

xchange r 110

en/dollar e Y

Quantity of dollars

Figure 7.2 Shifts in the foreign exchange market and deviations from PPP.

E 5 120 5 P JA /P US . The announced change in monetary policy has an immediate effect on

Suppose initially PPP holds, so that

the exchange rate because currencies are traded continuously throughout the day. Prices of goods and services will change much more slowly. In the short run the ratio of the price level in Japan to the price level in the United States may remain unchanged at 120. So while E falls today to 110 in Figure 7.2 , the ratio of the national price levels is still equal to the initial exchange rate of 120, and there is an apparent deviation from PPP.

Therefore, periods with important economic news will be periods when PPP deviations are large—the exchange rate adjusts while prices lag behind. In addition to the differential speed of adjustment between

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today for goods that are to be delivered several months later. If we compare goods prices and exchange rates today to evaluate PPP, we are using the exchange rate applicable to goods delivered today with prices that were set some time in the past. Ideally, we should compare contract prices in each country at the time contracts are signed with the exchange rate that is expected to prevail in the future period when goods are actually delivered and payment is made. If the exchange rate actually realized in the future period is the same as that expected when the goods prices were agreed upon, then there would be no problem in using today’s exchange rate and today’s delivered goods prices. The problem is that, realistically, exchange rates are very difficult to forecast, so that seldom would today’s realized exchange rate be equal to the trader’s forecast at some past period.

Let us consider a simple example. Suppose that on September 1, Mr. U.S. agrees to buy books from Ms. U.K. for d1 per book. At the time the contract is signed, books in the United States sell for $2, and the cur- rent exchange rate of E $/d 5 2 ensures that the law of one price holds—a d1 book from the United Kingdom is selling for the dollar equivalent of $2 (the pound book price of 1 times the dollar price of the pound of $2). If the contract calls for delivery and payment on December 1 of d1 per book and Mr. U.S. expects the exchange rate and prices to be unchanged until December 1, he expects PPP to hold at the time the payment is due. Suppose that on December 1, the actual exchange rate is d1 5 $1.50. An economist researching the law of one price for books would compare book prices of d1 and $2 with the exchange rate of E $/d 5 1.50, and examine if E $/d 5P US /P UK . Since 1.50 , 2/1, he would conclude that there are important deviations from PPP. Yet these deviations are spurious. At the time the prices were set, PPP was expected to hold. We generate the appearance of PPP deviations by comparing exchange rates today with prices that were set in the past.

The possible explanations for deviations from PPP include factors that would suggest permanent deviations (shipping costs and tariffs), factors that would produce temporary deviations (differential speed of adjustment

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served as a basis for economic policy discussions. The next section will provide an example of policy-related information contained in PPP measurement.

DEVIATIONS FROM PPP So far the discussion has included several reasons why deviations from