What is PPP?

Three versions of PPP have traditionally been used in the literature: the law of one price, which relates exchange rates to prices of individual homogeneous goods in different countries; absolute PPP, which relates exchange rates to overall price levels; and relative PPP, which relates exchange rate changes to inflation rates.

The law of one price states that when there are no transaction costs or trade barriers (such as tariffs or quotas), the prices of identical goods sold in different countries should be the same when expressed in a common currency. Empirically, the law of one price appears to hold well for homogeneous primary commodities traded on major exchanges, when adjustments are made for contract differences and delivery lags. Not surprisingly, however, the prices of differentiated products, such as manufactured goods and services, tend to deviate to a greater degree from the law of one price.

Absolute PPP extends the law of one price to the general price level. Absolute PPP predicts that the same basket of goods and services should cost the same amount in all countries when expressed in a common currency. Clearly, if the law of one price holds for every good, then absolute PPP should also hold. Absolute PPP, however, requires the parity relationship to hold only on average for all goods—not strictly for each good.

Absolute PPP provides a specific equilibrium concept for the nominal exchange rate, namely, the PPP exchange rate. This is defined as the rate that equalizes the prices of a common basket of goods in two different countries. Deviations between the market exchange rate and the PPP exchange rate are viewed as short-lived, as they should be eliminated by arbitragers purchasing goods in one country and selling them in another.

Despite their intuitive appeal, the empirical usefulness of the law of one price and of absolute PPP is limited. Transportation and information costs and institutional impediments to trade, such as tariffs and quotas, may limit consumers’ and firms’ responses to crosscountry price differences, thus preventing absolute price levels from being equalized internationally. Relative PPP is a yet weaker condition than absolute PPP and predicts only that changes in nominal exchange rates should equal the difference between domestic and foreign inflation on equivalent baskets of goods. If PPP is judged to hold in some particular year, one can obtain, from a time series of the inflation differential, the implied PPP nominal exchange rate, which can then be compared with the market exchange rate.

Deviations from PPP

Most economic theories suggest that PPP should hold in the long run for traded goods, assuming that measurement problems involved in constructing comparable price deflators can be resolved (see below). Empirical evidence on the validity of PPP is mixed, however (see the article by R. MacDonald for a survey of this evidence). On the one hand, there is a growing amount of evidence suggesting that PPP represents a reasonable characterization of long-run movements in industrial countries’ exchange rates and traded goods’ prices. On the other hand, there is ample evidence that PPP does not explain well the behavior of industrial countries’ exchange rates in the short run. Furthermore, when exchange rates and price movements are compared between industrial and developing countries—either the long run or the short run—PPP is clearly rejected, as large differences between inflation differentials and bilateral exchange rate changes persist in most cases over long horizons.

Research on exchange rates has considered four main reasons for deviations of real exchange rates from their PPP value: “hysteresis” effects due to adjustment costs; nominal price rigidities; imperfectly substitutable traded goods; and structural changes in technology and demand, particularly between traded and nontraded goods and services. The first two factors explain why PPP can fail over short horizons, while the last two can cause persistent failure of PPP.

“Hysteresis” models of trade attribute temporary deviations from PPP to the presence of adjustment costs in trade. These costs, which include the marketing of new products abroad, expanding or reducing production or distribution lines, and altering brand recognition, imply that trade flows need not respond to small changes in real exchange rates, as only large departures from PPP would trigger exporters’ response.

Sticky price models of exchange rates recognize the different speed of adjustment between financial markets and goods markets: the former respond swiftly to exogenous shocks, while the latter adjust more slowly. As a result, unanticipated changes in monetary conditions may cause nominal exchange rates to deviate temporarily from their long-run PPP equilibrium.

A third factor generating departures from PPP is the imperfect substitutability among different countries’ traded goods, which allows exporters to adjust prices to local market conditions, failing to offset changes in exchange rates by corresponding price changes. In this situation, cross-country differences in growth rates and in the response of trade to income growth can cause persistent changes in real exchange rates, and hence long-lasting deviations from PPP.

Chart 1

Comparing real exchange rate indicators

Japan: Real effective exchange rates

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Sources: IMF, International Financial Statistics, various issues, and staff estimates. ¹ Does not include data on China from 1975 to 1980.

Finally, but perhaps most important, differential rates of technical change in the traded and nontraded sectors have long been recognized as a cause of sustained movements in equilibrium real exchange rates and, therefore, as a reason for the persistent failure of PPP. This is because, while market competition may keep prices of tradables broadly aligned internationally, prices of nontradables need not move together in different countries. Thus, if the real exchange rate between two countries is computed using price deflators that include both tradable and nontradable goods (such as the consumer price index (CPI) or the GDP deflator), then countries with faster growth of productivity in the traded sector (notably manufacturing) than in the nontraded sector (notably services), will exhibit a tendency toward real appreciation.

This phenomenon (the so-called Balassa-Samuelson effect) is often advanced as an important factor underlying the long-term appreciation of industrial countries’ real exchange rates relative to developing countries, but also as explaining movements in equilibrium real exchange rates among industrial countries. Japan, for instance, is often cited as the classic case of a country where faster growth of productivity in the traded vs. nontraded goods sectors relative to its trading partners has caused a real appreciation of its currency. Chart 1 illustrates this fact by displaying two different measures of the yen’s real effective exchange rate, one defined in terms of a composite price index (the CPI) and one defined in terms of a tradable-only index (the export unit value index), for the period from 1975 to 1994. The chart highlights the sharp appreciation of the CPI-based real exchange rate of the yen, and the contrasting broad constancy of the export price-based real exchange rate. The divergence between the two indicators provides clear evidence of the impact of Japan’s fast growth of productivity in the export sector.

In summary, while it is useful to think of “competitiveness” as the relative position of a country’s exchange rate with respect to its long-run equilibrium value, it is not always easy to distinguish empirically between a change in the real exchange rate that reflects a change in competitiveness or a structural change that leads to a persistent change in the equilibrium real exchange rate. Indeed, it is misleading to regard every real depreciation as an improvement in a country’s competitiveness, as this may reflect a simultaneous decline in both the current real exchange rate and its long-run equilibrium value. If, for example, world demand for a particular primary commodity declines, the price of this commodity will fall. Both the long-term equilibrium and the current value of the real exchange rate of a country specializing in the production of that commodity will then depreciate. Clearly, however, this country will not be able to sell its products with any greater ease at the lower exchange rate.

This difficulty of assessing the dynamics of equilibrium real exchange rates, combined with statistical problems such as constructing qualitatively homogeneous baskets of goods and services, is central to any analysis of competitiveness. Furthermore, temporary deviations of current exchange rates from their medium- or long-run equilibria do not necessarily call for policy intervention, for they do not necessarily reflect a market failure. As noted above, real exchange rate fluctuations may well reflect optimal market re-sponses to a variety of exogenous shocks, which policymakers need not be called upon to correct.

Assessing competitiveness

Owing to the difficulty involved in measuring changes in international competitiveness, economists and policymakers rely on a variety of indicators to provide a broad assessment—however imprecise—of developments in real exchange rates that may affect a country’s ability to trade in world markets. These indicators differ primarily in their use of different price indices to deflate nominal exchange rates. For instance, a real exchange rate index based on the prices of tradable goods is defined as the ratio of a weighted average of the home country’s prices of exported goods to a weighted average of its partner countries’ prices of exported goods, all expressed in the same currency. A rise in this indicator is viewed as signaling an increase in a country’s export prices above their “world” level, and hence a loss of competitiveness for the home country in its export markets.

Chart 2

Trade flows and competitiveness

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Sources: IMF, International Financial Statistics, various issues, and staff estimates.

The main practical shortcoming of an export-based index of competitiveness is that it does not include all potentially exportable goods, but only those that are priced sufficiently low—at the current exchange rate—to be exported. Furthermore, if traded goods are close substitutes, then an export-based real exchange rate is likely to show little variation, as exporters will adjust prices quickly in response to exchange rate changes—even though operating profits may vary as a result. Chart 1 shows that this has indeed been the case in Japan. If exporters “price to market” by altering profit margins in the short run, an export-based index of competitiveness would provide little information on the long-term profitability of domestic producers relative to their foreign counterparts.

More comprehensive measures of price competitiveness can be constructed on the basis of either aggregate price deflators or of unit labor costs. A GDP-based real exchange rate, for instance, would reflect the ratio of the relative prices of nontraded to traded goods at home and abroad, so that a rise in this index would indicate either a loss of competitiveness in the traded goods market, or a greater incentive to allocate resources to the nontraded goods sector at home. In addition to GDP deflators, other broad indicators of competitiveness involve wholesale price indices, value-added deflators, and CPIs. Wholesale and value-added measures tend to be very imprecise, lack cross-country comparability, and are typically available only for the manufacturing sector, often with a substantial delay. CPIs are available on a more timely basis and with greater frequency, but reflect taxes and other institutional distortions, as well as prices of imported goods, thus making the associated measures of competitiveness less indicative of the prices faced by producers.

A real exchange rate index defined in terms of relative unit labor costs (ULCs) in the traded goods sector typically compares the profitability of nonlabor factors in producing manufactured goods at home and abroad. Implicit in this measure is the notion that exchange rates operate to equilibrate the rate of return to nonlabor factors of production across countries. ULC-based indicators have the advantage of being defined rather similarly across countries, although an unduly restrictive focus on the manufacturing sector is typically required to assure this homogeneity. Furthermore, because they are defined in terms of unit (or average) labor costs, they provide only a rough approximation of the relative incentives for labor allocation at home and abroad, which should be measured by marginal labor costs. Because the relationship between marginal and average labor costs varies with capital/output ratios, changes in unit labor costs may reflect only changes in capital/output ratios that are unrelated to competitiveness. Nonlabor costs also include costs other than the remuneration to capital, such as the rental of land and the cost of intermediate goods and primary commodities. In principle, labor cost indices could be corrected for the share of value added domestically, but this correction is difficult to carry out in practice. ULC-based indicators also tend to become available with delay and are often subject to large measurement errors.

Recent experience

How useful are the competitiveness indicators discussed above as predictors of exchange rate pressure and changes in trade volumes? A recent study by P. Turner and J. Van’t dack (see suggestions for further reading) cautiously suggests that standard indicators of competitiveness provide a useful picture of trends in exchange rates, prices, and productivity in the main industrial countries. L. Lipschitz and D. McDonald studied the evolution of Germany’s competitiveness during the 1980s vis-à-vis its European partners and showed that the ability of ULC-based real exchange rates to predict changes in European trade shares could be enhanced by adjusting this indicator to account for movements of value-added deflators. This study also suggested that the inability of standard GDP-based and CPI-based indicators of competitiveness to predict the pattern of market shares during this period could be explained by the slower rate of productivity growth in Germany’s traded goods sector vis-à-vis its partners. I. Marsh and S. Tokarick compared the ability of several competitiveness indicators to predict trade flows. They found evidence of a long-run response of trade to competitiveness, but little evidence of such linkage in the short run. None of the indicators examined seemed to uniformly outperform the others in terms of predictive power.

Some recent studies have also tried, with some success, to link market-based expectations of exchange rate changes to macroeconomic “fundamentals,” including competitiveness. F. Caramazza, for example, found that investors’ anticipations of a realignment of the French/German exchange rate mechanism (ERM) parity from 1987 to 1991 could be explained in large part by variables such as inflation rates and export competitiveness. L. Bartolini found similar results for Ireland, while A. Rose and L.E.O. Svensson reached more mixed conclusions.

The difficulty involved in establishing a clear link between real exchange rates and trade can be illustrated by examining the behavior of three of the real exchange rate indices discussed above and the trade balance in the United States and Japan from 1980 to 1994 (Chart 2). Because of the strong volatility of nominal exchange rates relative to that of prices, the different indicators of competitiveness tend to be highly correlated in the short run. The main exception is the slow response of Japan’s export unit value index to the appreciation of the yen in the second half of the 1980s, which partly reflects the effort of Japanese firms to maintain market shares despite unfavorable exchange rate fluctuations. Chart 2 also shows that whereas for the United States, real exchange rate appreciations have been broadly associated with a declining trade balance, the opposite has been true for Japan.

Conclusion

Changes in competitiveness are important, yet only partial, determinants of external positions. Policymakers are likely to be interested in developments in a country’s competitiveness—particularly when these developments are the results of specific policies—as these crucially affect trade performance. A country’s competitiveness, however, reflects a variety of factors that affect relative profit opportunities in the tradables and non-tradables sectors, including structural and cyclical developments in productivity and demand, and financial market conditions. Competitiveness indicators alone are unlikely to adequately account for these macroeconomic “fundamentals,” which are likely to affect the intertemporal dynamics of trade flows no less than exchange rates do. In fact, these “fundamentals” are likely to lead to long-lasting changes in equilibrium real exchange rates, and hence may underlie the observed long-term trends in the competitiveness indicators themselves. Changes in competitiveness generate economic forces that move real exchange rates toward their long-term equilibrium, but a more comprehensive framework is needed to explain changes in the equilibrium rates themselves.

A longer version of this article was drafted as a chapter of Exchange Rates and Economic Fundamentals, IMF Occasional Paper No. 115, co-authored with P Clark, T. Bayoumi, and S. Symansky.