Introduction

The Beginnings of PPP

First articulated by scholars of the Salamanca school in sixteenth-century Spain, purchasing power parity (PPP) is the disarmingly simple empirical proposition that, once converted to a common currency, national price levels should be equal.

The basic idea is that if goods market arbitrage enforces broad parity in prices across a sufficient range of individual goods (the law of one price), then there should also be a high correlation in aggregate price levels.

While few empirically literate economists take PPP seriously as a short-term proposition, most instinctively believe in some variant of purchasing power parity as an anchor for long-run real exchange rates. Warm, fuzzy feelings about PPP are not, of course, a substitute for hard evidence.

Consensus on a Couple Basic Facts

There is today an enormous and ever-growing empirical literature on PPP, one that has arrived at a surprising degree of consensus on a couple of basic facts.

1. First, at long last, a number of recent studies have weighed in with fairly persuasive evidence that real exchange rates (nominal exchange rates adjusted for differences in national price levels) tend toward purchasing power parity in the very long run. Consensus estimates suggest, however, that the speed of convergence to PPP is extremely slow; deviations appear to damp out at a rate of roughly 15% per year.

2. Second, short-run deviations from PPP are large and volatile. Indeed, the one-month conditional volatility of real exchange rates (the volatility of deviations from PPP) is of the same order of magnitude as the conditional volatility of nominal exchange rates. Price differential volatility is surprisingly large even when one confines attention to relatively homogeneous classes of highly traded goods.

The Purchasing Parity Puzzle

The purchasing power parity puzzle then is this:

How can one reconcile the enormous short-term volatility of real exchange rates with the extremely slow rate at which shocks appear to damp out?

Most explanations of short-term exchange rate volatility point to:

• financial factors such as changes in portfolio preferences

• short-term asset price bubbles

• monetary shocks (see, for example, Maurice Obstfeld and Rogoff, forthcoming). Such shocks can have substantial effects on the real economy in the presence of sticky nominal wages and prices.

Consensus estimates for the rate at which PPP deviations damp, however, suggest a half-life of three to five years, seemingly far too long to be explained by nominal rigidities. It is not difficult to rationalise slow adjustment if real shocks, shocks to tastes and technology, are predominant. But existing models based on real shocks cannot account for short-term exchange rate volatility.

Layout for the Paper

• Section 2 gives a brief account of the purchasing power parity doctrine’s empirical origins. 

• In Section 3, I consider some of the various ways in which PPP can be construed; the alternative approaches to defining PPP bring out many of the main issues and problems underlying testing and implementation.

• Section 4 looks at the startling empirical failure of the law of one price, a central building block of PPP that posits that similar goods should sell for similar prices across countries. Most economists recognise that there are frequent violations of the law of one price, but those not familiar with recent research will probably be stunned by the pervasiveness of the disparities. Indeed, some recent studies have shown that price differentials across countries for very similar consumer goods are typically more volatile than price differentials within a country for very dissimilar goods.

• Section 5 looks at a spate of recent studies that have finally relieved researchers of the embarrassment of not being able to reject the random walk model for real exchange rates.

• Section 6 looks at some modifications to purchasing power parity that are often used in practice and asks under what circumstances they provide a better model of the long-run real exchange rate. This section includes evidence on Béla Balassa’s (1964) and Paul Samuelson’s (1964) hypothesis that prices for non-traded goods tend to be high in rich countries relative to poor ones. I also consider differentials in government spending and current account imbalances as variables that affect medium to long-term deviations from PPP.

• Section 7 discusses some recent vector autoregression work that aims to decompose the shocks underlying real exchange rate changes.

• In the final, concluding section, I argue that it is difficult to explain the volatility and persistence of PPP deviations without recognising that international goods markets are not yet nearly as highly integrated as domestic goods markets.

Section 2: Gustav Cassel and the Birth of PPP as an Empirical Tool

The modern origins of purchasing power parity trace to the debate on how to restore the world financial system after its collapse during World War I.

Bretton Woods Gold Standard

Prior to the war, most countries adhered to the gold standard, in which their currencies were convertible to gold at fixed parities. The exchange rate between two currencies then simply reflected their relative gold values.

After the outbreak of World War I, however, maintaining the gold standard became impossible as speculators became justifiably concerned that countries would devalue their currencies in an effort to gain seigniorage revenues; the gold standard was quickly abandoned.

When the war ended, countries faced the very real problem of deciding how to reset exchange rates with minimal disruption to prices and government finances. Simply returning to pre-war exchange rates made no sense because the various belligerents had such vastly differing inflation experiences during the war.

Purchasing Power Parity's Great Use

In a series of influential articles, the Swedish economist Gustav Cassel (1921, 1922) promoted the use of PPP as a means for setting relative gold parities.

Basically, he proposed calculating cumulative CPI inflation rates from the beginning of 1914 and using these inflation differentials to calculate the exchange rate changes needed to maintain PPP.

Though purchasing power parity had been discussed previously by classical economists such as John Stuart Mill, Viscount Goschen, Alfred Marshall, and Ludwig von Mises, Cassel was really the first to treat PPP as a practical empirical theory.

Cassel's writings were quite influential and PPP calculations played an important role in the debate over Britain's much criticised decision to try to restore its pre-war mint parity with the dollar in 1925; see John Maynard Keynes (1932) and Officer (1976a).

Today, various versions of purchasing power parity are used in a wide range of applications:

• from choosing the right initial exchange rate for a newly independent country

• to forecasting medium and long-term real exchange rates

• to trying to adjust for price differentials in international comparisons of income

Section 3: Variants of PPP

1. The Law of One Price

2. Absolute and Relative Purchasing Power Parity

3. Indices for Measuring Absolute PPP

4. Empirical Evidence on the Law of One Price

Section 4: Empirical Evidence on the Law of One Price

1. International vs Intra-National Price Volatility

2. The Volatility of the Law of One Price Deviations in the 20th Century vs Earlier Ones

3. Possible Frictions: Transportation Costs, Tariffs, Non-tariff Barriers, Pricing to Market

Section 5: Long Run Convergence to PPP

1. The Embarrassing Resiliency of the Random Walk Model

2. Tests Based on Long Horizon Data Sets

3. Tests of Convergence to PPP based on Cross-Country Data Sets

Section 6: Modifications to PPP

1. The Balassa-Samuelson Hypothesis

2. Mixed Evidence of the Balassa-Samuelson Hypothesis

3. Cumulated Current Account Deficits and Long-Run Real Exchange Rate Depreciation

4. Government Spending and The Real Exchange Rate

Section 7: Estimates of Convergence Based on Multivariate Vector Autoregression Models

Refer to paper

Section 8: Conclusion

One can restate the purchasing power parity puzzle as follows:

How is it possible to reconcile the extremely high short-term volatility of real exchange rates with the glacial rate (15% per year) at which deviations from PPP seem to die out?

It would seem hard to explain the short-term volatility without a dominant role for shocks to money and financial markets. But given that such shocks should be largely neutral in the medium run, it is hard to see how this explanation is consistent with a half-life for PPP deviations of three to five years. It is possible that a different picture of the persistence of PPP deviations will emerge from multivariate VAR models, but thus far such models also suggest very slow convergence.

One is left with a conclusion that would certainly make the godfather of purchasing power parity, Gustav Cassel, roll over in his grave.

It is simply this: International goods markets, though becoming more integrated all the time, remain quite segmented, with large trading frictions across a broad range of goods. These frictions may be due to:

• transportation costs

• threatened or actual tariffs

• non-tariff barriers

• information costs

• lack of labour mobility

As a consequence of various adjustment costs, there is a large buffer within which nominal exchange rates can move without producing an immediate proportional response in relative domestic prices.

International goods markets are highly integrated, but not yet nearly as integrated as domestic goods markets.

This is not an entirely comfortable conclusion, but for now there is no really satisfactory alternative explanation to the purchasing power parity puzzle.