Thuyết trình môn tài chính quốc tế giá cả trong nền kinh tế mở ngang giá sức mua prices in the open economy purchasing power parity

The law of one price in the domestic economy Example 1 • there are people who make a living out of exploiting just such situations • buy up as many tickets as they could in the cheap lo

Chapter 2

GVHD: PGS.TS Nguyễn Khắc Quốc Bảo Nhóm HVTH:

• Tô Thị Phương Thảo

• Nguyễn Hoàng Minh Huy

PRICES IN THE OPEN ECONOMY: PURCHASING POWER PARITY

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The law of one price in the domestic economy

If two goods are identical, they must sell for the same price.

 In the context of the domestic economy, the law of one price states simply that:

The law of one price in the domestic economy

 Example 1

• Imagine that Michael Jackson is giving a concert at Wembley Stadium in London, a fortnight from now

• All the tickets have been sold at face value through the usual distribution channels across the UK

• but excess demand has created a black market

The law of one price in the domestic economy

 Example 1

BIRMINGHAM

£50

?

The law of one price in the domestic economy

 Example 1

• there are people who make a living out of exploiting just such situations

• buy up as many tickets as they could in the cheap location (Manchester) and sell them immediately in the dear location

The law of one price in the domestic economy

The law of one price in the domestic economy

The law of one price in the domestic economy

 Example 1

• As a specialist trader in large blocks, the scalper’s transaction costs are minimal.

The law of one price in the domestic economy

 Example 1

• Arbitrage will cease to be profitable when the price differential is no greater than the transaction cost per item.

PB is the price of a ticket in Birmingham

PM is the price in Manchester

C is the transaction cost

The law of one price in the domestic economy

 Example 1

Are there any other factors we have neglected that may prevent even our modified law of one price from asserting itself?

• ticket touting, whatever its economic benefits, is more or less illegal

• transaction cost, C, will be substantially affected by the fact that the business deals involved may amount to a crime

Risk of arrest is the only risk involved In a pure arbitrage transaction, there are no trading risks in the normal sense

Arbitrageurs can be regarded as selling their tickets in Birmingham almost at the same time that they buy in Manchester, so that their actual trading risk is zero The absence of risk is a distinguishing feature of arbitrage.

The law of one price in the domestic economy

 Example 1

The interaction of normal traders – fans wanting to attend the concert and the organizers supplying the seats – these are the ultimate determinants of the equilibrium, ‘central’ price

The equilibrium price may also be affected in the short run by the activity of a different species of ticket scalper – one who

holds on to tickets in expectation of higher prices later.

Speculation is the activity of holding a good or security in the hope of profiting from a future rise in its price.

The speculator–tout buys tickets and holds on to them so as to sell them when the time is right – typically, outside the stadium immediately before the concert starts

The law of one price in the domestic economy

 Example 1

In any market, we may potentially have three different kinds of agent at work:

• traders (the fans, whose tastes condition their demand, and the organizers, whose costs determine the

supply)

• arbitrageurs (touts who exploit local price variations)

• speculators (scalpers who hold on to tickets in the hope of making a ‘killing’)

The law of one price in the domestic economy

 Example 2

Could the price in Manchester ever deviate from the price in London?

The transaction cost, C, may be quite substantial in this case, simply because potatoes are costly to move from one end of a country to

The law of one price in the domestic economy

 Example 3

Take a typical manufactured good, for example, a folding umbrella made in China Can we be sure that its price will be uniform across the UK?

the law of one price only relates to identical goods

Don’t prices vary even for genuinely identical goods – same model, same

producer, same label?

Yes The reason lies in large part in the fact that a shopper buys not only the umbrella but also the services of the retailer who sells

it If the shop itself supplies a retailing service that is above average in prestige, in convenience, in friendliness or helpfulness or length of opening hours, it will be able to sell its service at an above average price, which will take the form of a premium on some or all of its wares.

The law of one price in the domestic economy

 Example 4

Compare the price of houses in the north (Manchester) and the south (London).

• Houses cannot be moved from one end of the country to the other The transaction cost is not simply high, it is infinite –

at least in the short run.

• Even if we are careful enough to choose a given type of house for comparison

(say, semi-detached, three bedrooms, garage and so on), we cannot avoid the

problem that a house in Manchester is simply not the same asset as a

house in London.

The law of one price in the domestic economy

 Example 5

Can the price of a haircut in London deviate from that in Manchester?

Nothing in economics relies on a distinction between the market for goods and the market for services.

Even if demand is similar, the cost of the main hairdressing inputs (wages, rent and so on) is greater in London, so the supply

curve is further to the left.

The law of one price in the domestic economy

The law of one price in the open economy

 Example 1

An enterprising New York travel agent is selling tickets for the concert – mainly to attract customers for his cut-price trips

to London If you make him an offer, however, he will sell the concert tickets separately.

The law of one price in the open economy

 Example 1

‘compound purchase’: first, buy the dollars, then use the dollars to buy the tickets In the closed economy context, we exchange domestic money directly for goods

When buying from another country, we first have to exchange domestic money for foreign money, then exchange the

foreign currency for the foreign goods.

The law of one price in the open economy

 Example 1

Whenever you undertake a compound purchase, buying an item for cash, then using that item to buy a second, the overall price you will have paid will be the

product of the two prices.

Sterling price of a dollar × dollar price of a ticket = sterling price of a ticket

S: exchange rate

PNY: the price in dollars advertised in New York,

SPNY : the overall price to a Londoner

The exchange rate is the price of a unit of foreign currency, measured

in units of domestic currency.

PL = SPNY + C

The law of one price in the open economy

The law of one price in the open economy

 Example 2 & 3

A tariff is a tax levied on goods crossing an international border.

where it is levied at a flat rate per unit, it can be regarded simply as inflating the value of our transaction portmanteau term, C

More frequently, it consists of a more or less ad valorem tax

In the case of agricultural products, there may be other barriers to international trade Some countries impose quotas that are more or less rigid limits on the quantity of a good that may be imported or, occasionally, exported.

The law of one price in the open economy

A digression on price indices

If we are to make any progress, we are going to have to turn our attention to the general price level.

A (consumer) price index is a weighted average of individual product prices, with weights determined by

expenditure shares.

Price of salt to double! Petrol also up by 3%!

A digression on price indices

How can we take simultaneous account of the fact that the price of salt has gone up by 100% and the price of petrol by 3%, while everything else has remained unchanged?

• One answer would be to take a simple (unweighted) average of the price

A digression on price indices

In general terms, the calculations are misleading because they contain the hidden assumption that all products, or product categories, are equally important.

For most purposes, however, they are not all equally important, particularly when we are concerned to answer a question like:

how great an increase in my salary, in my pension or in my student grant do I require in order to compensate for this latest round of price increases?

 The way deal with this problem is by weighting the price increase for each individual product by a fraction equal to its proportionate contribution to the average household’s total expenditure.

A digression on price indices

• Suppose weights of 0.1% for salt and 5.0% for petrol are found Then the calculation is simply:

conclusion that the cost of living in the UK would rise by 0.033 × 200 = 6.6% In the event, the quantity of petrol consumed fell

drastically across the industrialized world, so that the ultimate rise in the cost of living was far less than this calculation would suggest

A digression on price indices

If we look at percentage rates of price increase, we will be dealing with

common units (per cent) and the weighted average will have an obvious interpretation, which is the rise in the price of the typical good or service during the period in question.

Another problem: it is a rise in price, but since when? A price that has

fallen by 2% in the past year may have fallen by 60% in the last two years but risen by 400% over the last 10

 base period

 Retail (or consumer) Price Index (RPI), which is based on a sample of prices in shops and other retail outlets, and the Wholesale (or producer) Price Index (WPI), which measures prices ‘at the factory gate’.

PURCHASING POWER PARITY

Pi = SPi * với i = 1… N (2.3)

PURCHASING POWER PARITY

Pi = SPi * với i = 1… N (2.3)

consumed in the two countries

=> N such goods => Equation 2.3 could be repeated N times over, with i = 1 N

What can be said about the price index for the UK compared to the USA?

PURCHASING POWER PARITY

Not much – unless making an additional assumption:

=> Now, Equation 2.3 will apply equally to the general level of prices, so that we can write:

P: home country’s price index

P*: foreign country’s price index

of the absolute purchasing power parity doctrine

PURCHASING POWER PARITY

Absolute PPP doctrine:

arbitrage or the normal competitive trading processes, then it is to these forces one should look for

an explanation of how PPP asserts itself

=> The PPP hypothesis is a natural consequence or a by-product of the law of one price, reflected at aggregate level

P1: The general level of prices, when converted to a common currency, will be the same in every

country.

PURCHASING POWER PARITY

Suppose, instead of the prices of individual goods and services, the general price levels themselves that are brought directly into the relationship predicted by PPP

Assuming each national price level is determined by that country’s macroeconomic policy

in the same way it would be if the economy were completely closed

=> By given these independently determined national price levels, exchange rate could move to satisfy PPP

PURCHASING POWER PARITY

First, It amounts to treating Equation 2.4 as one that determines the exchange rate

=> a simple version of the monetary model of the exchange rate ( Chapter 5)

Second, it follows that this scenario presupposes a floating exchange rate

When the exchange rate is fixed: PPP either fails to work or it is assumed to function in a different way, which is precisely the subject of the monetary model of the balance of payments (Chapter 5).

PURCHASING POWER PARITY

would be sufficient that upward deviations from the law of one price in the case

of one good were offset by downward deviations in another case

Third, in principle at least, this approach does not rely on the law of one price

But it it might still apply, even if there were wide divergences between countries in the price of individual goods and services

PURCHASING POWER PARITY

no less restrictive:

If one good with a weight of 1% is overpriced by 50%, contributing (0.01 × 50%) = 0.5% to the general price level, there has to be another good contributing exactly −0.5%, for example, one carrying a 0.5% weighting underpriced by precisely 1%

PURCHASING POWER PARITY

Most economists would agree that none of the published price indices is anything like a perfect measure of the appropriate price level for PPP

+ The shortcomings may be the same ones:

the Retail Price Index is an imperfect measure of the cost of living: problems of accounting for differences of quality between products, problems of sampling prices actually paid, rather than listed prices, and so on

+The shortcomings may be of the kind that are really only significant in an open economy context: different tax regimes and differing degrees of provision of public goods

PURCHASING POWER PARITY

variables which are unobservable and only very distantly related to what we actually observe, that is, the published UK and US price statistics

other observable variables, then the PPP hypothesis becomes fully operational

Of course, that does not make it any more likely to be true

PURCHASING POWER PARITY

rate movements, particularly insofar as they impinge on international competitiveness If the general level of prices is a reasonably accurate index of the cost of production in a country (and this is almost certain to be the case) then the ratio of price levels for any two countries will serve as a measure of relative competitiveness

PURCHASING POWER PARITY

would not only be constant, it would in some sense be equalized across different countries

goods and services represented by the general price level

In practice, international competitiveness has been far from constant in the post-war world => economists often wish to measure deviations from PPP The concept most used for is the real exchange rate:

The real exchange rate is the price of foreign relative to domestic goods and services

PURCHASING POWER PARITY

Formally, it is measured by:

PURCHASING POWER PARITY

+The UK price index = 200

+The US price index = 250

+The exchange rate is £0.80 = $1.00

The relative purchasing power parity hypothesis states that:

One country’s inflation rate can only be higher (lower) than another’s to the extent that its exchange rate depreciates (appreciates).

PURCHASING POWER PARITY

PURCHASING POWER PARITY

country if its exchange rate falls pro rata

a base for the price index

=> That is why, although absolute PPP often figures in theoretical models, it is only relative PPP that can actually be tested by an examination of the evidence