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I would like to thank Professor Ronald McKinnon for his advice and encouragement, and Mr. Howard Handy for useful comments.
Previously, McKinnon estimated PPP exchange rates using the Cassel-Keynes method, with 1975-76 as the base period and producer prices as the preferred index. More recently, he has relied on the estimates derived by the long-run averaging method and the price pressure method which are presented later in this paper. However, formal exposition of these methods, especially the latter, has not taken place. For an informal discussion of these methods, see McKinnon and Ohno (1989).
These two sides of Cassel’s (1921) concept of PPP are easily recognizable: “Given a normal freedom of trade between two countries, A and B, a rate of exchange will establish itself between them and this rate will, smaller fluctuations apart, remain unaltered as long as no alteration in the purchasing power of either currency is made and no special hindrances are imposed upon the trade” (positive, p. 36). “The purchasing power parities represent the true equilibrium of the exchanges, and it is, therefore, of great practical value to know these parities” (normative, p. 38).
In The New Palgrave Dictionary of Economics, Vol. III (1987), Dornbusch opens the discussion of PPP thus: “Purchasing Power Parity (PPP) is a theory of exchange rate determination. It asserts (in most common form) that the exchange rate change between two currencies over any period of time is determined by the change in the two countries’ relative price levels” (p. 1075).
One important reason for this is the relatively cheap nontradable goods and services in LDCs. When incomes are compared using exchange rates which reflect competitiveness in the tradable sector, incomes in LDCs tend to be understated.
We assume that PPP is computed using price indices with identical weights, and that transportation costs are negligible.
Keynes put it thus: “it would promote confidence, and furnish an objective standard of value, if, an official index number having been compiled of such a character as to register the price of a standard composite commodity, the authorities were to adopt this composite commodity as their standard of value in the sense that they would employ all their resources to prevent a movement of its price by more than a certain percentage in either direction away from the normal” (Keynes, 1923b, pp. 215-216).
Between 1975 and 1985, consumer prices rose 19.9 percent relative to wholesale prices in Japan. Corresponding figures for the United States and West Germany are 6.9 percent and -0.5 percent, respectively.
McKinnon (1988a) argues that, upon discovery of natural gas or oil fields, the Dutch were better off under the Bretton Woods fixed-rate system of the 1960s because the ensuing reallocation of domestic resources proceeded gradually over the entire decade, than the British in the late 1970s whose currency appreciated rapidly in both nominal and real terms which wiped out a large chunk of British manufacturing in a matter of a few years.
Needless to say, stability in the average of tradable prices is perfectly consistent with variability in the prices of individual tradable goods. If an innovation occurs in the production of integrated circuits, their absolute (hence relative) price will decline by the same amount in dollar, yen, and mark. It is also conceivable that the relative price between primary commodities and manufactured goods will steadily change while the overall tradable price level remains constant.
“When two currencies have been inflated, the new normal rate of exchange will be equal to the old rate multiplied by the quotient between the degrees of inflation of both countries” (Cassel, 1921, p. 37).
While most authors agree that pass-through is generally different from unity, underlying reasons for this conclusion differ from one model to another. For example, Knetter (1989), Krugman (1987b), Mann (1986), and Yamawaki (1988) attribute various degrees of pass-through to dissimilar conditions of demand or supply in each country (in static profit-maximization). Baldwin (1988), Baldwin and Krugman (1986), Foster and Baldwin (1986), Dixit (1987, 1988), and Froot and Klemperer (1988) stress the role of hysteresis in dynamic pricing behavior. Daniel (1987), Klein (1988), and Murphy (1988) contend that different shock structures in the macro economy lead to different optimal price responses to the exchange rate signal.
The pass-through coefficient could exceed unity in certain special cases. One sufficient condition for this (in Feenstra’s model) is that the elasticity of demand is decreasing in price and marginal costs are declining.
However, for simplicity we assume that both error terms are individually AR1 with the same autoregressive coefficients. This assumption permits a simple structure of the error term in relative form, in equation (8). A similar assumption is made for bilateral productivity shocks below.
The LSQ procedure of the TSP statistical package is used.
Our model estimates eight parameters including those associated with serial correlation. In the unconstrained version, each of the relative price equation and the relative cost equation would have free parameters on a constant, two lagged dependent variables, two concurrent independent variables, and two lagged independent variables--thus fourteen free parameters in all.
From the asymptotic variance-covariance matrix of the estimated parameters, the correlation between lnθ1 and lnθ2 is estimated to be 0.96 for yen/dollar and 0.86 for mark/dollar.