Theoretical Description and Empirical Evidence free essay sample

Among the considerable amount of examples the Purchasing Power Parity (PPP) and its building block – the Law of One Price (LOP) seem to stand out the most due to their fundamental importance for modern economics. Officer (1986) even argues that without the imposition of LOP, there would not even be the traditional pure theory of international trade. â€Å"Without this law, much of the â€Å"monetary theory†, too, would have to be reconstructed† (Officer, 1986). In this essay the Law of One Price and the theory of Purchasing Power Parity (PPP) will be presented. First, a theoretical definition of PPP will be given with short explanation what makes it so important for the contemporary economics and finance. Second, a definition of the LOP will be made as a building block of the PPP. A discussion built around the statement of Isard (1977) that â€Å"In the assumed absence of transport costs and trade restrictions, perfect commodity arbitrage insures that each good is uniformly priced (in common currency units) throughout the world – the â€Å"law of one price† prevails† will follow with reference to some key empirical research. We will write a custom essay sample on Theoretical Description and Empirical Evidence or any similar topic specifically for you Do Not WasteYour Time HIRE WRITER Only 13.90 / page Some support the law whereas other go as far as suggesting dismissal or at least reformulation of the law. Due to the vast amount of research on the topic this essay will attempt to only summarise and present the findings very briefly. In conclusion the essay will show that even if the law of one price is true, we have no way of verifying it except for a small class of goods or in specific context. The â€Å"theory-data gap†Ã¢â‚¬â€ between the specifications which allow the theory to apply and the conditions under hich the relevant data can be collected in the real world—is much too large, and shows no signs of becoming smaller. What is Purchasing Power Parity (PPP)? The concept of purchasing power parity (PPP) can be traced back to as early as 16th-century writings of scholars from the University of Salamanca in Spain (Officer, 1982, cited in Rogoff, 1996). Yet, the definition of PPP as we use it in modern economics is relatively new and is usually credited to Gustav Cassel (1918). The idea behind it is fairly straight forward and intuitive: when measured in common currency, the monies of different countries should have the same purchasing power and be able to purchase the same basket of goods (Reinert et. al. , 2009). Stated otherwise if the market arbitrage enforces broad parity in prices across a sufficient range of individual goods (the law of one price, which is discussed further down), then there should also be a high correlation in aggregate price levels (Rogoff, 1996). To illustrate it with a simplified example the PPP states that in the â€Å"long run†, if ? 00 can buy a certain basket of goods in UK, then, after converting it into US Dollars, the sum should be able to buy approximately the same basket of goods overseas in the United States. 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. Absolute and Relative form To describe the relationship between exchange rates and national price levels economists usually use one of the two main conditions of PPP – absolute or relative. The first states that the spot exchange rate is determined by the relative prices of similar baskets of goods. This suggests that we could determine the ‘real’ or PPP exchange rate that should exist if markets were efficient by comparing the prices of identical products denominated in different currencies. On the other hand, the relative PPP holds that PPP is not particularly helpful in determining what the spot rate is today, but that the relative change in prices between two countries over a period of time determines the change in the exchange rate over that period. More specifically, if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. The commonly agreed statement is that the absolute PPP is less (if at all) useful than the relative one. Salvatore (2001) argues that â€Å"the absolute PPP theory cannot be taken too seriously / / whenever the PPP theory is used, it is usually used in its relative formulation†. Rogoff (1996) points out that the biggest problem for not using absolute PPP is the lack of data to conduct viable tests. With very few exceptions there are no indices for internationally standardised basket of goods. The absolute version of the PPP theory has in its roots The Law of One Price Abstracting from complicating factors such as transportation costs, taxes, and tariffs, the law of one price states that any good that is traded on world markets will sell for the same price in every country engaged in trade, when prices are expressed in a common currency. The law of one price is based upon the idea that market participants exploit arbitrage opportunities by purchasing (selling) a good in one market and selling (purchasing) it in another until there is a price equilibrium. A significant amount of empirical research has been done on the validity of the Law of One Price (LOP) and although called a law, it has probably been violated more than any other economic law (Miljkovic, 1999). Authors have found the LOP to hold among some products and not others (Ardeni, 1989; Baffes, 1991; Zanias, 1993). Other authors have questioned the testing techniques used (Pippenger, 2004; Goodwin 1990; Goodwin, Greenes, Wohlgenant, 1990). Further down few key empirical studies will be presented with their findings and conclusions. Due to the vast amount of research on the topic this essay does not claim being either fully comprehensive nor very detailed as its aim is to give rather good idea about the main problems regarding PPP and its foundation – the Law of One Price. Empirical evidence on LOP Early empirical literature on the validity of the law of one price finds little support in favour of the hypothesis. In recent years, however, evidence coming from the exploitation of new data sets, either in the form of panel data or longer time series data, tend to support the view that the law of one price does hold in the long run (Goldberg and Verboven, 2005; Cecchetti, Mark, and Sonora, 2002). The documented price convergence in the European car market during the integration process is one of the few pieces of evidence that are in favour of LOP (Goldberg and Verboven 2005). Some early research Among the early studies to document the size and volatility of LOP deviations across seemingly highly traded goods were Isard (1977) and Richardson (1978). Isard examined disaggregated data (including transactions price data) on U. S. , German, Canadian, and Japanese exports for a range of highly traded goods, such as apparel, industrial chemicals, paper, and glass products. He found that deviations from the law of one price are large, persistent, and to a significant extent simply reflect nominal exchange rate movements (Isard, 1977). Richardson (1978) finds some evidence of commodity price arbitrage between the United States and Canada, but the arbitrage is far from perfect. Using an even more disaggregated data set on transactions prices for the United States and Japan, Giovannini (1988) finds significant price differentials not only in relatively sophisticated manufacturing goods, but even in commodity manufactures such as screws, nuts, and bolts. Corroborating Isards and Richardsons results, he finds that LOP deviations are highly correlated with exchange rate movements. Despite his attempt to verify the LOP focusing on a small number of commodities: wheat, wool, beef, sugar, tea, tin, and zinc Ardeni (1989) got quite unfavourable results. His conclusion is that the LOP has held only for the following pairs of goods: U. S. wheat (export price) and Australian wheat (import price), U. S. wheat (export price) and Canadian wheat (export price), and U. S. tea (import price) and English tea (import price) (Ardeni, 1989). Some support after all Partly supportive findings were made by Baffes (1991). Using the data for wheat, beef, sugar, zinc, tin and wool for US, Australia and UK he produced results supporting more than half of the considered commodities. His test was based on commodities. Moreover, he concluded that eventual failure of the LOP asa long-run relationship is a pricespedfic and time-period-specific problem rather than a general failure. He also concluded that a possible reason for the LOP failure is transportation cost. Major problem with Baffess conclusions is that they are based on results that suggest a negative relationship between prices (Miljkovic, 1999). Using disaggregated data Iregui and Otero (2008) applied stationary tests to examine evidence of market integration for a relatively large sample of food products in Colombia. Within a panel context and after allowing for cross sectional dependence, the tests they conduct provide much more evidence supporting the view that food markets are integrated or, in other words, that the law of one price holds for most products. But why does it fail? Rashid (2007) distinguishes three key conditions necessary for the LOP to be plausible: existence real competition at each location (multiple sellers); standardised, bulk sale commodities with specialised traders having sufficient resources to trade; and last but not least rapid attainment of equilibrium. However, numerous examples from both academics and everyday experience prove these three conditions practically unattainable for the need of LOP. First, the traditional idea of LOP assumes that there are at least two (preferably more) suppliers at every point in space. This, however, can be automatically rejected by the numerous examples of near perfect monopolies like the AAFES  which has a monopoly on retail sales at overseas military installations or the infamous but yet very important  salt commission in China a legal monopoly founded almost 1300 years ago. Second, the trend of modern consumerism is toward more personalized products, which not only increases the number of goods to be considered but also makes price discrimination more likely (Barzel, 2005). Third, in the past few decades a rapid shift from mass manufacturing to services can be observed with the services making up to 63. 2% of the global GDP (CIA World Factbook, 2011). This is to suggest that all past empirical studies and recent publications based on prices of manufactured products are to be given less attention and weight when drawing conclusions about the viability of LOP. This poses a great problem as services are notoriously known to be both highly personalised and subject to price discrimination (Hill, 1987 cited in Rashid, 2007). Among the other reasons that receive attention from prominent trade economists are pricing to market (Froot and Klemperer, 1989; Knetter, 1993; Krugman, 1987), exchange rate risk (Giovannini, 1988), and geographical separation of markets including transportation costs (Krugman, 1987) and institutional factors that influence price settings in different markets (Pippenger, 2004). Some other arguments focus on the presence of non-tradable inputs of production as a major reason for the failure of the LOP (Giovannini, 1988, Richardson, 1978). Ardeni (1989) argues that costs of arbitraging can be high, at least for short periods of time, especially for markets strongly influenced by international agreements. Finally, errors in data and definitions of various prices, is another explanation for some of the deviations. Presuming that measurement errors are white noise, they should not alter long-run tendencies and thus are not a valid explanation. The evidences from the various tests are so inconclusive that some economists have been led to propose a reformulation of the law. Rashid (2007) argues that the law of one price should be a process and not a result. Supporting this idea Barzel argues that the law in its current form should be regarded as a tendency (Barzel 2005) defining it in the following way: â€Å"As information about a commodity improves, its price variability will decline†. Such a reformulation does not necessarily make the new law more testable since the difficulties of measuring â€Å"information† and its â€Å"spread† are at least as great as those of measuring the LOP at present Empirical evidence for PPP As PPP is based on LOP the empirical evidence supporting or rejecting the later can easily be used to infer for the first. However, here are some (out of many) studies that have attempted to focus primarily on the PPP. Koukouritakis (2009) uses the Johansen cointegration methodology to test the validity of PPP for the 12 new members of the EU with respect to the Eurozone. The results suggest that the long-run PPP hypothesis holds only for 4 out of the 12 new countries since the symmetry and proportionality restrictions cannot be rejected for them. The study concludes that for the remaining 8 countries the long-run PPP hypothesis does not hold suggesting that the reason might be that the difference between each country’s inflation and the Eurozone’s inflation may not be reflected in the respective nominal exchange rate. Abuaf and Jorion (1990) conduct an empirical study over the long-run validity of PPP concluding that â€Å"PPP may hold in the long run after all†. The authors attribute the negative results obtained in previous empirical research to the poor power of the tests rather than evidence against PPP. This is why Hakkio (1986) concludes that, although the hypothesis that the exchange rate follows a random walk cannot be rejected, not much weight should be put on this conclusion. However the study by Abuaf and Jorion is based on the consumer price index (CPI). Pippenger (2004) severely criticises the usage of CPI or Producer price index (PPI) because they are sticky and irrelevant as any adjustments from PPP will actually take place in the future hence affecting the futures and forwards prices instead of the current retail or wholesale prices. Goodwin, Greenes and Wohlgenant (1990) come in support of the criticism by analysing and testing PPP using futures and forward contracts. â€Å"Burgernomics† THE BIG MAC INDEX A seemingly funny, yet surprisingly accurate example of how prices of a same or very similar good differ across different countries would be the infamous Big Mac example. Since 1986, The Economist has published an annual comparison of the prices of the McDonald’s Big Macâ„ ¢ burger in various countries around the world, evaluating prevailing exchange rates on the basis of international price differences.