Download The Balassa-Samuelson effect

Lecture 12:
SOURCES OF DEVIATIONS FROM
PURCHASING POWER PARITY (PPP)
• Barriers to International Integration
–
–
–
–
Transportation costs
Tariffs & non-tariff trade barriers
Border frictions
Currencies.
• Non-Traded Goods
– The relative price of NTGs
– The Balassa-Samuelson Effect
– Deviations from the Balassa-Samuelson line.
Barriers to International Integration
Long distance transport costs
fell sharply during the late 19th century.
Real Freight Rates for Jute from Calcutta to UK (1884=1.00)
Saif I. Shah Mohammed & Jeffrey G. Williamson, 2004,
"Freight rates and productivity gains in British tramp shipping 1869–1950." Explorations in Economic History 41.2: 172-203.
By 1914, low
transport costs,
UK-led free trade,
& the Pax
Brittanica allowed
arbitrage between
the US & UK
in wheat.
Agricultural
products still
feature high
trade barriers,
preventing price
arbitrage.
API-120 - Prof. J. Frankel
CROSS-BORDER TRADE BARRIERS: KEY FINDINGS
(after controlling for trade policy & geographic variables)
Gravity
model of
volume of
trade shows:
Evidence of
arbitrage in
price
differentials
shows:
Even across
the CanadianU.S. border,
firms trade with fellow
citizens 20 x as much as
cross-border
(5 x, after controlling for FTA, etc.) --
McCallum (1995); Helliwell (1998).
frictions in crossing
the border >>
frictions in going from one
end of country to the other
-- Engel & Rogers (1996) .
API-120 - Prof. J. Frankel
Looking at trade among a
large sample
of countries,
a difference in currencies,
in particular,
cuts trade by 3
-- Rose (2000).
different currencies, in
particular, explain some
of the border frictions
-- Parsley & Wei (2001); Cavallo,
Neiman & Rigobon (2014).
Engel & Rogers “How Wide is the Border?” AER (1996)
Crossing the border, e.g., from Vancouver to Seattle,
adds more friction into price arbitrage than traveling
the length of the continent from Atlantic to Pacific.
API-120 - Prof. J. Frankel
Andrew Rose, 2000, “One Money, One Market? The Effect
of Currencies on International Trade,” Economic Policy.
The gravity model of bilateral trade
shows that such barriers as distance,
tariffs, borders, etc., still matter.
• Rose (2000): A reduction in
bilateral exchange rate
variability encourages trade.
• More surprisingly, joining a
currency union results in an
estimated tripling of trade
among the partners,
• even after controlling for
colonial history, etc.,
(exp(1.2)=3).
NonTraded
Goods &
Services
Why is the cost
of living so high in
Tokyo and so low
in Mumbai?
Why was Buenos
Aires in 2001
more expensive
than Paris or
Frankfurt ?...
API-120 - Prof. J. Frankel
In 2004, Tokyo
was still very
expensive.
But Buenos Aires
had fallen
far below Paris
or Frankfurt.
Why?
The peso
collapsed
in 2002.
API-120 - Prof. J. Frankel
The real exchange rate varies with each country’s relative price of NTGs.
Q ≡
(𝐸)(𝐶𝑃𝐼∗)
(𝐶𝑃𝐼)
𝐸 (𝑃𝑇𝐺 ∗1−α 𝑃𝑁𝑇𝐺 ∗α )
≡
(𝑃𝑇𝐺1−α 𝑃𝑁𝑇𝐺 α )
where α ≡ weight of NTGs in price basket.
𝐸𝑃𝑇𝐺 ∗ (𝑃𝑇𝐺 ∗−α 𝑃𝑁𝑇𝐺 ∗α )
assuming arbitrage works for TGs.
≡
−α
α
(𝑃𝑇𝐺 ) (𝑃𝑇𝐺
𝑃𝑁𝑇𝐺 )
Q=
(𝑃𝑁𝑇𝐺 ∗/𝑃𝑇𝐺 ∗)α
(𝑃𝑁𝑇𝐺 /𝑃𝑇𝐺)α
API-120 - Prof. J. Frankel
One important application of TG/NTGs, esp. for long-run trends.
The Balassa-Samuelson effect:
(PNTG /PTG) -- and therefore 1/Q -- rises with countries’ real incomes.
The usual B-S reason: Productivity growth takes place in
the TG sector, reducing prices there relative to wages and PNTG.
The statistical relationship between income per capita
and the absolute real exchange rate is well documented.
Some cross-section studies:
• the original Balassa article (1964)
• Rogoff (1996):
•
• recent studies of RMB
undervaluation (see appendix 2).
= .04 + .37
(.09)
(.04)
It takes more work to verify that productivity growth
operates via the relative price of NonTraded Goods.
• E.g., DeGregorio, Giovannini & Wolf (1994).
API-120 - Prof. J. Frankel
The
original
Belassa
article
showed
1960 levels.
API-120 - Prof. J. Frankel
Distinguishng TGs from NTGs is difficult in practice.
Estimates of tradability calculated for about 200 products,
as the worldwide trade/output ratio, relative to average tradability of all products
If more than 2%
of the sector is traded,
it must be tradable.
Tradable
goods
NonTradable
Goods
Data: 20 OECD countries, 1985-1999, from UNIDO (2000) & US.Commerce Dept. (2002).
Source: Robert E. Lipsey & Birgitta Swedenborg, 2010, Review of World Economics.
http://www.nber.org/papers/w13
De Gregorio,
Giovannini &
Wolf (1994),
“International Evidence
on Tradables and
Nontradables Inflation”
In almost all countries, the ratio of NTG prices
to TG prices rises over time (“Baumol’s cost disease”).
Japan had the strongest trend during the post-war period.
API-120 - Prof. J. Frankel
The countries with
the strongest
productivity growth
tend to show the
strongest upward
trend in the relative
prices of NTGs
(1970-1985) .
API-120 - Prof. J. Frankel
Balassa-Samuelson relationship:
Absolute price levels are higher in rich countries
(real exchange rates are lower).
1/Q
G.Alessandria & J. Kaboski, 2008, “Why are Goods So Cheap in Some Countries? ” Bus.Rev, Fed.Res. Bank of Philadelphia, Q2. Fig.1
Balassa-Samuelson relationship
re-estimated
• Every 1% increase in real income/capita
is associated on average with .38% real appreciation.
• In any given year, many countries lie far off the line.
• E.g., China’s RMB appeared “undervalued,”
even relative to the B-S relationship,
– by 25% in 2009.
• What causes currencies to deviate from the B-S line?
– Devaluation/revaluation, or
– Fixed nominal exchange rate plus inflation or rapid productivity growth.
– But gaps from the B-S line tend to correct 1/2-way per decade.
API-120 - Prof. J. Frankel
API-120 - Macroeconomic Policy Analysis I
Professor Jeffrey Frankel, Kennedy School of Government, Harvard University
APPENDIX 1 -- PASSTHROUGH
Jose Campa & Linda Goldberg (2005)
• Passthrough of exchange rate changes to import
prices is low into the US market (especially in the SR).
• But for most other countries, the passthrough
coefficient is above 50% even in the SR, and
not statistically different from 1 in the LR.
• In most, the coefficient fell during the 1990s.
• Compositional differences of price indices
(e.g., more weight on oil vs. autos) can alone explain
part of the variation in passthrough coefficients.
• The passthrough coefficient depends on
inflation & exchange rate volatility.
API-120 - Prof. J. Frankel
Jose Campa &
Linda Goldberg,
2005, “Exchange Rate Pass
Through into Import Prices,"
Review of Econ. & Stats.
API-120 - Prof. J. Frankel
APPENDIX 2: VALUATION OF CHINA’S RMB
Balassa-Samuelson estimated for 2000
Cross-section of 118 countries
Fitted values
CHN
logRER00
.370385
Log of real
exchange
value of
country’s
currency (1/Q)
CHN
-2.15096
6.17768
10.6917
loginc00
Log of real income
3 paths to an “undervalued” currency: (i) devaluation, (ii) low inflation,
(iii) fixed exchange rate during a long period of rapid productivity growth.
Frankel (2006): “On the Yuan: The Choice Between Adjustment Under a Fixed Exchange Rate and Adjustment under a Flexible Rate,” Understanding the Chinese Economy, G.Illing, ed. (OUP).
1
Balassa-Samuelson
estimated
for 2005
The Balassa-Samuelson
Relationship
-1
-.5
0
.5
2005
-3
-2
-1
0
1
Log of Real Per capita GDP (PPP)
2
coef = .23367193, (robust) se = .01978263, t = 11.81
Source: Arvind Subramanian (2010), PB10-08, Peterson Institute for International Economics.
Undervaluation of the 2005 RMB in the estimated regression = 26%.
Compare to estimate for 2000 (Frankel 2005): 36%.
As recently as 2009 (Chang 2012) : 25% .22
Balassa-Samuelson estimated for 2011
In 2014, the ICP released new absolute price data.
“Is the Renminbi Still Undervalued? Not According to New PPP Estimates”
by M.Kessler & A.Subramanian, PIIE, May 2014
Benchmark years
GDP per capita (in PPP dollars)
RMB undervaluation (percent)
2005
2011
4,802
10,057
-34.5
-9.7
API-120 - Prof. J. Frankel
APPENDIX 1 –
BalassaSamuelson
relationship
Source: Gene Chang
Estimate of
overvaluation/undervaluation
measured relative to the
Balassa-Samuelson line
for 2009.
“Theory and Refinement of the Enhanced-PPP
Model for Equilibrium Exchange Rates,” 2011.
China: 25% undervaluation
The RMB continued to appreciate in real terms.
It has approximately completed its adjustment,
as also shows up in the trade balance.
http://www.jeffrey-frankel.com/2012/03/26/china-adjusts/
API-120 - Prof. J. Frankel