International Finance Theory and Policy
by Steven M. Suranovic

Finance 30-4

Problems and Extensions of PPP

Problems with the PPP Theory

The main problem with the PPP theory is that the PPP condition is rarely satisfied within a country. There are quite a few reasons that can explain this and so, given the logic of the theory, which makes sense, economists have been reluctant to discard the theory on the basis of lack of supporting evidence. Below we consider some of the reasons PPP may not hold.

Transportation costs and trade restrictions - Since the PPP theory is derived from the law of one price, the same assumptions are needed for both theories. The law of one price assumed that there are no transportation costs and no differential taxes applied between the two markets. These means that there can be no tariffs on imports or other types of restrictions on trade. Since transport costs and trade restrictions do exist in the real world this would tend to drive prices for similar goods apart. Transport costs should make a good cheaper in the exporting market and more expensive in the importing market. Similarly, an import tariff would drive a wedge between the prices of an identical good in two trading countries' markets, raising it in the import market relative to the export market price. Thus the greater are transportation costs and trade restrictions between countries, the less likely for the costs of market baskets to be equalized.

Costs of Non-Tradable Inputs - Many items that are homogeneous, nevertheless sell for different prices because they require a non-tradable input in the production process. As an example consider why the price of a McDonald's Big Mac hamburger sold in downtown New York city is higher than the price of the same product in the New York city suburbs. Because the rent for restaurant space is much higher in the city center, the restaurant will pass along its higher costs in the form of higher prices. Substitute products in the city center (other fast food restaurants) will face the same high rental costs and thus will charge higher prices as well. Because it would be impractical (i.e., costly) to produce the burgers at a cheaper suburban location and then transport them for sale in the city, competition would not drive the prices together in the two locations.

Perfect information - The law of one price assumes that individuals have good, even perfect, information about the prices of goods in other markets. Only with this knowledge will profit-seekers begin to export goods to the high price market and import goods from the low priced market. Consider a case in which there is imperfect information. Perhaps some price deviations are known to traders but other deviations are not known. Or maybe only a small group of traders know about a price discrepancy and that group is unable to achieve the scale of trade needed to equalize the prices for that product. (Perhaps they face capital constraints and can't borrow enough money to finance the scale of trade needed to equalize prices). In either case, traders without information about price differences will not respond to the profit opportunities and thus prices will not be equalized. Thus, the law of one price may not hold for some products which would imply that PPP would not hold either.

Other market participants - Notice that in the PPP equilibrium stories, it is the behavior of profit-seeking importers and exporters that forces the exchange rate to adjust to the PPP level. These activities would be recorded on the current account of a country's balance of payments. Thus, it is reasonable to say that the PPP theory is based on current account transactions. This contrasts with the interest rate parity theory in which the behavior of investors seeking the highest rates of return on investments motivates adjustments in the exchange rate. Since investors are trading assets, these transactions would appear on a country's capital account of its balance of payments. Thus, the interest rate parity theory is based on capital account transactions.

It is estimated that there are approximately $1 trillion dollars worth of currency exchanged every day on international Forex markets. That's one-eighth US GDP, which is the value of production in the US in an entire year! Plus, the $1 trillion estimate is made by counting only one side of each currency trade. Thus, that's an enormous amount of trade. If one considers the total amount of world trade each year and then divide by 365, one can get the average amount of goods and services traded daily. This number is less than $100 billion dollars. This means that the amount of daily currency transactions is more than ten times the amount of daily trade. This fact would seem to suggest that the primary effect on the daily exchange rate must be caused by the actions of investors rather than importers and exporters. Thus, the participation of other traders in the foreign exchange market, who are motivated by other concerns, may lead the exchange rate to a value that is not consistent with PPP.

Relative PPP

There is an alternative version of the PPP theory called the "relative PPP theory." In essence this is a dynamic version of the absolute PPP theory. Since absolute PPP suggests that the exchange rate may respond to inflation, we can imagine that the exchange rate would change in a systematic way given that a continual change in the price level (inflation) is occurring.

In the relative PPP theory, exchange rate changes over time are assumed to be dependent on inflation rate differentials between countries according to the following formula:

Here the percentage change in the $ value between period 1 and 2 is given on the lefthand side. The righthand side gives the differences in the inflation rates between Mexico and the US, evaluated over the same time period. The implication of relative PPP is that if the Mexican inflation rate exceeds the US inflation rate, then the dollar will appreciate by that differential over the same period. The logic of this theory is the same as in absolute PPP. Importers and exporters respond to variations in the relative costs of market baskets so as to maintain the law of one price, at least on average. If prices continue to rise faster in Mexico than in the US, for example, price differences between the two countries would grow and the only way to keep up with PPP is for the dollar to appreciate continually versus the peso.

International Finance Theory and Policy - Chapter 30-4: Last Updated on 7/10/99