I. Derivation of Effective Exchange Rates, Weighting Procedures, and Operational Implications of Mathematical Formulations
II. Available Relative Price (Cost) Indices Adjusted for Exchange Rate Movements and Alternative Indicators
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Mr. Maciejewski, economist in the International Capital Markets Division of the Exchange and Trade Relations Department, was economist in the Consultation Practices Division when this paper was prepared. He received his doctorate from the University of Dijon and also studied at the Institute of Economic Research of the University of Hitotsubashi in Tokyo and at the Bologna Center.
The informational content of nominal effective exchange rate indices and indices of the multilateral exchange rate model (MERM) type has, however, been discussed extensively in the economic literature.
Hereinafter, termed adjusted relative price (cost) indices.
This alternative—and only correct—definition of the real effective exchange rate has been used in the economic literature (for instance, Bruno (1976)).
These are the only three instances of an effective exchange rate index discussed here, but a number of other possibilities exist, including currency baskets used in pegging certain national currencies.
As explained by Artus and McGuirk (1981, p. 275), the model is “a mathematical simulation model with emphasis on the specification of a fully consistent set of demand and supply equations for goods. Its theoretical structure is basically the Walrasian general equilibrium framework, simplified to a great extent by the use of input-output relationships.”
That is, by constraining output.
Taken into account in a consistent manner for all the industrial countries simultaneously.
Feltenstein, Goldstein, and Schadler (1979). In the suggested version, the underlying model focuses on only a few key behavioral relationships, that is, demand for money, demand for imports, determination of real expenditure, and supply of exports.
For example, an overall balance, surplus, or some specified improvement in the overall deficit recorded during a previous year or reference period.
For example, fiscal policy or tariff measures.
The process through which an equilibrium relative price is determined can be illustrated with a simple economic model, where (1) total production and total expenditure are divided into two categories—traded goods and nontraded goods and (2) constant terms of trade are assumed. The assumption of constant terms of trade helps to reduce the three-dimensional transformation function relating exportables, importables, and nontraded goods involved in the model into a two-dimensional function. Specifically, this assumption means that the three-dimensional function after trade contains a straight line in the plane relating exportables and importables. Two other key assumptions are involved—infinite mobility of resources in the production of traded versus nontraded goods, and short-term downward price and cost flexibility. The latter assumptions are of some importance in respect of adjustment process; for example, a required fall in the price of nontraded goods relative to traded goods sufficient to restore the original equilibrium relative price level may involve a considerable delay. Such a model has been used by Salter (1959) and Dornbusch (1975).
Assuming no sales taxes or factor taxes and no other distortions.
In this case, the base period should be more than a year to ensure that most of the effects of previous changes in relative prices (costs) are reflected in the selected balance of payments variable (e.g., the underlying external trade or current account).
For example, an external current account deficit, which is financed by recourse to capital inflows on a sustained basis.
The analysis of structural changes is expected, for instance, to identify and to remove the effects of policy priorities or choices on production that might have affected the external trade or current account outcome independently of relative prices (costs).
One such attempt to clarify the concepts of traded and nontraded goods in relation to the use of the most appropriate indices of relative prices was made by Goldstein and Officer (1979). The concepts of tradables and nontradables are also discussed briefly by Prachowny (1975, Chap. 2).
Or explain equally the economic behavior of each of the economic agents involved.
Also, the selected base year (or period) should not be too distant; otherwise, the calculated values may not be interpreted independently of the structural changes that occurred later.
Given the focus on international competitiveness, it is deemed that currency baskets, per se (i.e., based on the currency composition of trade), are not directly relevant for this study, owing to their narrow focus on the effects of exchange rate movements on the value of the selected variable during the base period. However, the available economic literature on the optimal peg may provide some useful insights about choosing relevant weighting procedures. (See, in particular, Williamson (1982), pp. 50 and 55.)
In this respect, some consideration should also be given to specific marketing arrangements within the reporting country (e.g., the amount of the receipts cashed by the official marketing agency may differ substantially from the amount of payments made by the same agency to producers, and lags involved in adjusting domestic producer prices to foreign prices).
If there were perfect competition and homogeneous products, the price in the importing country would reflect all the information necessary, and third-country data would be superfluous.
For example, the European Economic Community and the Organization for Economic Cooperation and Development (OECD).
For example, crude oil, petroleum products, and capital goods.
In practice, profit margins that result from contract prices in domestic currency are made to absorb some of the change in the exchange rate, as contract prices denominated in foreign currency are adjusted gradually. See Artus (1974) and Spitäller (1980).
Or closely related situations, for example, situations in which the producers in a given country are monopoly, or near-monopoly, suppliers faced with a downward-sloping world demand curve for their exported products or more specific cases, such as situations in which nonprofit-maximizing strategies (e.g., cost-plus pricing) are involved. Product differentiation is present whenever the products of individual sellers within a group that comprises a particular market are not regarded by consumers as being perfect substitutes. As a result of product differentiation, consumers may be willing to pay more for one variety of product than for another and may not be easily persuaded to change from one brand to another.
Such indices, which in theory would reflect marginal domestic costs (and sales taxes) to marginal foreign costs (and sales taxes), stand perhaps as the most readily available indices for intercountry comparisons.
However, such a statement would not apply in either case under tightly controlled external trade regimes.
This could be achieved, for instance, by cutting profit margins in foreign sales, which is an alternative action to raising prices; the question would then be how seriously profitability and investment are affected.
Such situations include those in which exports are produced and marketed against “kinked” demand curves (i.e., where price decreases do not help to increase the volume of sales much, since they are matched by other producers (inelastic demand), whereas price increases, which other competitors would not be expected to follow, will lead to declining sales).
That is, if the movements measured by the selected index do not reflect (or offset) movements in other factors that would preclude a change in market shares.
The required true export (import) price indicator is expected to be calculated on the basis of actual price and quantity data for the selected basket of goods on the assumption that “the pure export (import) price effect” can actually be isolated.
The index implicitly assumes that (1) the home country’s wholesalers and/or producers can change the prices of domestic import substitutes somewhat independently from developments in foreign prices of competing imports and (2) there is a strong demand in the home country for the products under consideration.
This is major information that indices of relative export prices cannot provide, despite improvements that they may show over time. In this respect, even for differentiated exports, it may be argued that relative cost indices are likely to be more comprehensive measures of international competitiveness than are relative price indices.
With marginal costs being appropriate for short-run analysis.
Under normal circumstances; however, see footnote 27.
The lack of proper data to help to select the most appropriate weighting system in a number of specific cases may be another problem. However, once (1) the specific set of market conditions under consideration is determined and (2) a specific policy objective or analytical question is clearly set, an appropriate weighting procedure can be chosen accordingly, and the potential loss of information is expected to be minimized.
As shown in the preceding subsections and in Appendix II, there is a reasonable presumption that different relevant or available price (cost) indices will best explain only certain categories of exports and import substitutes.
In addition, consumer prices (like wholesale prices) may include the so-called productivity bias, since they generally contain a relatively high proportion of nontradable goods (Balassa (1964)). However, there is no consensus on this issue, as other authors (e.g., Officer (1976 a)) would argue that such productivity bias does not exist.
For a detailed derivation, see Bonnie Loopesko (summer intern in Exchange and Trade Relations Department in 1980), “Derivation of an Index of Nominal Effective Exchange Rates” (mimeographed, August 15, 1980).
Allen (1975) has cogently argued for a more direct nexus between index number theory and practice, noting that the lack of good theoretical basis generally accounts for the imprecision and ambiguity of most index numbers used in practice.
However, the derivation is not based on an economic theoretical model, such as the constant utility underpinnings of price indices (although a similar model probably could be derived). Instead, a step is taken in the direction suggested by Allen (1975) by laying down precisely what the index is intended to measure and the economic logic underlying its derivation.
This question is similar to that posed by the Laspeyres index, which asks: Holding the consumption basket constant, what would be the change in the cost of purchasing the base period basket, given the change in prices from the base period?
That is, “the arithmetic average of prices of home currency in terms of partner currencies, relative to the base period, weighted by the partners’ shares in total exports of the home country.” Specifically, formulation (2) shows that the index can be rewritten so that the weights are simply bilateral export shares, that is, in the form that is generally used in calculating the effective exchange rate.
For a detailed derivation, see Anne Kenny McGuirk, “Derivation of Weights Used to Construct Indices of Competitiveness” (mimeographed, International Monetary Fund, August 1980).
In this formulation, the rightmost term represents the share of commodity i exported by country k to market j in total imports of commodity i by market j, weighted by the importance of the exports of commodity i by country x to market j in country x’s total exports to market j. The leftmost term measures the relative importance of market j in the country x’s total exports.
In this formulation, the weight Wxj is assumed to reflect the relative importance of competitor j to country x. Such a weight is measured by summing the share of country i’s import supplied by j (Mij) over all markets i multiplied by the share of k’s exports to i (Xxi). In this formulation, Mij denotes the importance of country j as a competitor/supplier to i, and Xxi that of country i as a market to x. This OECD specification (as well as the commodity-oriented specification presented in the next subsection) could probably be derived in a straightforward way from Armington’s (1969 a) original work on commodities differentiated by place of origin (including, in particular, Armington (1973)). Double-weighting procedures similar to the OECD formula can be improved further by incorporating the home suppliers’ effects. To do so, it would be sufficient, for instance, to replace Mi in the OECD formula by importables (Mi +
Such as (1) the same elasticity of substitution between any two pairs of competing products; (2) relative independence and constant elasticities of substitution between the competing products; and (3) the same elasticity of substitution not only between two countries but also between two pairs of competing products.
To illustrate this point, consider Zaïre’s exports. Since copper is its major export commodity, it is obvious that exports of copper to Belgium will be little affected by the price of French exports of wine to the same market.
Since log(x) = −log(1/x), the logarithmic distance between 0 and 1 is identical to that between 1 and infinity.
That is, identification, time reversibility, circularity and factor reversibility, change of units (homogeneity), proportionality, and uniqueness in the determination of relative changes.
The degree of dependence on the base dates can be assessed by measuring the quantitative differences in the levels indicated by both the arithmetic-averaging and harmonic-averaging techniques and the geometric-averaging method. Once such a dependence is assessed and the arithmetic (harmonic) averaging technique continues to be used, it will be necessary to rebase the index frequently so that the actual weights are not allowed to diverge substantially from the weights used initially in the selected weighting procedure. It should be kept in mind, however, that this will be nothing but a technical device that does not help to improve the economic meaning of the calculated indices.
Such indices are published regularly in International Monetary Fund, International Financial Statistics (IFS) for 13 industrial countries. They are sometimes termed indices of relative prices (costs) per se.
Which cover 13 OECD countries and focus on manufactures only.
That is, productivity indices abstracting from cyclical change in output per man-hour.
According to the OECD (1978), only Japan, the Federal Republic of Germany, Sweden, Finland, and Australia publish export price series and, at that time, the United States was reportedly experimenting with the construction of similar series.
Export unit values (as well as import unit values) are not equivalent to average values, which are in fact weighted averages of quantity relatives obtained in deflating aggregate value flows by an index of aggregate volume flows. In other words, a unit value index differs from a true price index in that the raw data used as a proxy for prices are in fact average values for a basket of commodities (i.e., nominal values divided by quantities). As such, export (import) unit values measure changes in the average value of exports (imports) per physical unit and cannot help to distinguish whether the change in unit value is due to a change in price per se or to compositional shifts in the selected basket of commodities.
The major shortcomings of these indicators are (1) the fact that no “pure price effect” can be isolated, even if it is based on standard Laspeyres price formula; (2) compositional shifts and changing coverage; shifts in the commodity composition of imports and exports are generally more rapid than are shifts in patterns of consumption (relevant for the consumer price index—CPI) or production (relevant for the wholesale price index—WPI); (3) potential distortions in value data, owing to errors in invoice; (4) noncomparability in terms of the mathematical formulation used; and (5) different weights used in constructing the index. However, available data on export or import unit value indices are such that they may be used to derive corresponding indices for specific groups or subgroups of commodity aggregates. As a result, the composition, coverage, and weighting of the export or import unit value indices may be made more comparable to those of the foreign price indicator used (e.g., wholesale prices).
Like the export and import unit value indices, WPIs usually suffer from the lack of straight comparability that arises from even wider differences in the scope, coverage, methods of comparison, and mathematical formulas used. As a result, intercountry comparisons may be distorted by serious biases; for ratios of domestic relative prices (defined as the ratio of export (import) unit values over wholesale prices), the combination of two conceptually different price (cost) indicators may simply result in statistically meaningless values. This is due to incomparability in timing; wholesale prices refer to prices at the date of the sales contract, whereas export (import) unit values are calculated ex post and, thus, refer to prices at the date of shipment across borders. However, like the export and import unit value indices, subsets of WPIs may be specifically derived either for manufactured goods only or for manufactured goods and services (using the related consumer price indices). In addition, unlike export (import) unit values, wholesale prices measure changes in prices rather than average values in primary markets.
That is, whenever wholesale prices are close to being industry selling prices.
For example, indirect taxes and the need for the distribution of weights to reflect adequately each commodity export’s importance in total production.
That is, including wages, salaries, social security premiums, and other employment taxes or related expenses.
This may not necessarily be so in reality, but other more comprehensive and more representative unit cost indices are generally not yet available.
For example, the costs of raw materials, semifinished products, capital, and financing. While this is likely to be verified where exports are effected by multinational firms, there is no guarantee that such situations may be verified in most of the other cases.
There are a number of other disadvantages. Like wholesale price and consumer price indices, unit labor cost indices—including the normalized and smoothed formulations developed by the Fund—also suffer from a lack of comparability. Normalized and smoothed formulations attempt to remove the influence of cyclical swings in conventionally measured productivity so that the cyclical variations in reported employment correspond to those in labor that has actually been involved in generating the related product. In addition, the smoother version takes four-quarter moving averages so that seasonal factors and effects of other special circumstances (e.g., strikes) can be eliminated. But, unlike CPIs, indices of unit labor costs usually cover tradable goods and are more directly linked to wage developments that generally have a large influence on production costs. However, unit labor costs are likely to be available only for the manufacturing sector. Hence, actual use of such indicators is likely to be restricted to the developed countries and a number of semiadvanced developing countries.
It is well known that productivity responds quickly and markedly to cyclical changes in demand pressures, while wages tend in general to respond only gradually to such pressures and sometimes even with a relatively long delay.
The procyclical properties of profits are well known.
However, explicit measurement of such indices has become increasingly feasible and reliable in recent years.
These two indices adjusted for exchange rate movements are widely used in the Fund and the OECD. The OECD has recently developed an index of total unit current costs for the manufacturing sector as a whole using weights derived from input/output data for those countries for which data on the prices of raw materials were available (OECD, 1978, p. 44).
That is, estimated output per man-hour under conditions of “normally” full utilization of capital and labor. See Artus (1977 a).
That is, lower levels of employed production factors and capacity utilization are by definition expected to be gradually incorporated into the moving averages or trends involved in computing normalized unit labor costs.
For example, on production functions and the mean age of capital stock.
In this regard, it should be noted that CPIs cannot reflect differentiated production patterns; accordingly, should the production structures be rather labor intensive in one country and rather capital intensive in other countries, CPIs are not likely to be able to approximate factor costs reasonably well in the countries under consideration.
Unlike wholesale price indices, CPIs are heavily influenced by trends in the price of goods and services that are in the nontraded category. In addition, a number of goods and services included in such indices have virtually nonexistent demand price elasticity. Capital goods (a major component in international trade) are usually not covered, while their inclusion on account of the factor market effects involved in intercountry comparison could be required conceptually. Also, food items generally account for a relatively large share in most of the available CPIs; they may represent between 20 percent and 35 percent in developed countries and from 20 percent to more than 60 percent in developing countries. Moreover, agricultural trade is so restricted in most countries that price movements of domestically sold output usually differ substantially from international market prices. However, the lack of comparability is likely to be a less serious problem, especially in developed countries, where the sample group’s purchases tend to become more similar from one country to another and from one income group to another.
Ideally, what would be required is an index of the home country’s GDP deflator for exports of goods and/or services to the competitors’ GDP deflator but such an index is not likely to be available in most (including developed) countries.
GDP deflators may best be viewed as a composite indicator of the cost of all primary factors of production. (For an interesting analysis of GDP estimates, see Sato (1976).) GDP deflators are computed as quotients of the current and constant estimates of value added. However, such estimates may not always be factor-cost based (as they should be ideally) and thus may incorporate the effects of changes in indirect taxes and subsidies. Unlike the WPI, the GDP deflator refers only to domestically produced goods and services and is not expected to be affected by double counting. At the same time, however, the GDP deflator may not represent a final product price. For instance, GDP deflators for the manufacturing sector generally exclude the cost of intermediate inputs from all the nonmanufacturing sectors. Thus, the GDP deflator may be a less comprehensive price indicator than is the WPI.
Ideally, GDP estimates should be based on factor costs, so as to abstract from the effects of changes in indirect taxes. However, GDP deflators are often estimated in terms of market prices and thus may give rise to serious problems of comparability. Also, GDP deflators are sometimes derived from constant-factor cost series and current market price data.
This is particularly true of situations in which relative prices change rapidly and drastically or in situations that are characterized by relatively large shifts in the proportions of the factors of production utilized. In such cases, however, the use of production data may be substituted.
A difficult problem in using GDP deflators for both intercountry cost comparisons and calculations of domestic relative costs is that the differences in the calculated values may reflect differential productivity growth. In this respect, how much adjustment should be made to eliminate the resulting distorting effects is not entirely clear. Another problem with GDP deflators is that they are usually made available only after considerable delay and that they are also subject to frequent revisions.
It may be argued, on this basis, that the index could also be used as a relevant index of international price competitiveness.
This is so because export unit values tend to reflect prices at the customs post and, thus, past developments. However, the comparison of wholesale prices for exported products with export unit values may be used to study the evolution of the prices of the major export commodities relative to those of the other exports.
Unless a specific GDP deflator for nonexports of goods and services can be derived or is available.
Should the case under study involve some significant long-run changes in the capital/labor ratio, the resulting biases could be alleviated by correcting the normal output per man-hour that is used in calculating the normal unit labor costs for the effect of the changes in the capital/labor ratio. (See Artus (1977 b), P-16.)
For example, lack of uniformity across the countries under consideration.
For example, an increase in the U.S. CPIs is likely to have little effect on relative prices in Ivory Coast.
For example, the consumer prices in Saudi Arabia may have little influence on the price of the crude oil that is imported by the reporting country under study.
In other words, such a ratio is expected to approximate a ratio that measures the relative price of foreign tradables to domestic tradables and nontradables.
Unless a specific GDP deflator for imports of goods and services can be derived or is available.