Barriers to International Integration – Transportation costs – Tariffs & non-tariff trade barriers – Border frictions – Currencies. Non-Traded Goods –The

• 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.

Lecture 9: SOURCES OF DEVIATIONS FROM

PURCHASING POWER PARITY (PPP)

Long distance transport costsfell sharply during

the late 19th century.

NBER WP 9531

Real Freight Rates for Jute from Calcutta to UK (1884=1.00)

API-120 - Prof. J. Frankel


By 1914, low transport costs, free trade in the UK, & the Pax Brittanica, allowed arbitrage between the US & UK in wheat.


Agricultural products still feature high trade barriers, preventing price arbitrage.


CROSS-BORDER TRADE BARRIERS: KEY FINDINGS (after controlling for trade policy & geographic variables)

Even across the Canadian-U.S. border,

Looking at trade among a large sample of countries,

Gravity model of volume of trade shows:

firms trade with fellow citizens 20 x as much as cross-border (5 x, after controlling for FTA, etc.) -- McCallum (1995); Helliwell (1998).

a difference in currencies, in particular, cuts trade by 3 -- Rose (2000).

Evidence of arbitrage in price differentials shows:

frictions in crossing the border >> frictions in going from one end of country to the other

-- Engel & Rogers (1996) .

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.


Rose (2000), the mostinfluential empirical paper in international monetary economics in the last 15 years:

Applying the gravity model of bilateral trade to a large sample of countries reveals

(exp(1.2)=3).

not only that a reduction in bilateral exchange rate variability encourages trade, even after controlling for common colonial history, etc., but that joining a currency union results in an estimated tripling of trade among the partners.


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 ?...

In 2004, Tokyo was still very expensive.

But Buenos Aires had fallen

far below Paris or Frankfurt.

Why?

The peso collapsed in 2002.



So the real exchange rate varies witheach country’s relative price of NTGs.

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.

• Rogoff (1996): = .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).

The statistical relationship between income per capitaand the absolute real exchange rate is well documented.Some cross-section studies:• the original Balassa article (1964)

• recent studies of RMB undervaluation (see below).


The originalBelassa articleshowed1960 levels.


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

Source: Robert E. Lipsey & Birgitta Swedenborg, 2010, Review of World Economics. http://www.nber.org/papers/w13239

Data: 20 OECD countries, 1985-1999, from UNIDO (2000) & US.Commerce Dept. (2002).

Tradablegoods

Non-Tradable

Goods

If more than 2% of the sector is traded,

it must be tradable.

http://www.nber.org/papers/w13239

In almost all countries, the ratio of NTG prices to TG prices rises over time (“Baumol’s cost disease”).

De Gregorio, Giovannini & Wolf (1994), “International Evidence on Tradables and Nontradables Inflation”

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) .



Rogoff (1996):

Again, countries with high incomes per capita tend on average to have high real currency values,as judged by absolute PPP.


Balassa-Samuelson relationshipre-estimated

• Every 1% increase in real income/capitais 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.

loginc00

Fitted values logRER00 CHN

6.17768 10.6917

-2.15096

.370385

CHN

Balassa-Samuelson estimated for 2000Cross-section of 118 countries

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).

Log of real exchange value of country’s currency (1/Q)

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.

19

-1-.

50

.51

Lo

g o

f P

rice L

evel

-3 -2 -1 0 1 2Log of Real Per capita GDP (PPP)

coef = .23367193, (robust) se = .01978263, t = 11.81

Compare to estimate for 2000 (Frankel 2005): 36%.As recently as 2009 (Chang 2012) : 25% .

The Balassa-Samuelson Relationship2005

Source: Arvind Subramanian (2010), PB10-08, Peterson Institute for International Economics.

Undervaluation of the 2005 RMB in the estimated regression = 26%.

Balassa-Samuelson estimated for 2005

“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 4,802 -34.52011 10,057 -9.7

In 2014, the ICP released new absolute price data.Balassa-Samuelson estimated for 2011

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.


Jose Campa & Linda Goldberg,

2005, “Exchange Rate Pass Through into Import Prices,"

Review of Econ. & Stats.


Estimates from Jeffrey Frankel, David Parsley, & Shang-Jin Wei, 2012, "Slow Pass-through Around the World: A New Import for Developing Countries?” Open Ec. Rev.


APPENDIX 1 – Balassa-

Samuelson relationship

China: 25% undervaluation

Estimate of overvaluation/undervaluationmeasured relative to the Balassa-Samuelson linefor 2009.

Source: Gene Chang“Theory and Refinement of the Enhanced-PPP Model for Equilibrium Exchange Rates,” 2011.


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/

Documents

Barriers to International Integration – Transportation costs – Tariffs & non-tariff trade barriers – Border frictions – Currencies. Non-Traded Goods –The