Empirical Tests of PPP Theory
PPP theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates. A country in which price inflation is running wild should expect to see its currency depreciate against that of countries with lower inflation rates. This is intuitively appealing, but is it true in practice? There are several good examples of the connection between a country’s price inflation and exchange rate position (such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed results.11 While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less.12 In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped capital markets. The theory is less useful for predicting short-term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates.
ANOTHER PERSPECTIVE The Starbucks Index
To test the Big Mac index, which applies the PPP theory using the price of a Big Mac in various markets to determine the equilibrium value of the foreign currency, The Economist established a Starbucks index in 2004. Like the Big Mac, a cup of Starbucks coffee can be found in many foreign markets and can be seen as a proxy for a basket of goods. The results of the Starbucks index followed the Big Mac index in most markets, except in Asia, where the former indicated that the dollar was at parity with the Chinese yuan; the Big Mac index suggested that the yuan was 56 percent undervalued. Neither of these consumer items is a good proxy for a basket of goods, but comparing their relative prices with exchange rates is an interesting and playful approach to quickly grasping how under- or overvalued the foreign currency is against the dollar.
The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the purchasing power parity puzzle. Several factors may explain the failure of PPP theory to predict exchange rates more accurately.13 PPP theory assumes away transportation costs and barriers to trade. In practice, these factors are significant and they tend to create significant price differentials between countries. Transportation costs are certainly not trivial for many goods. Moreover, as we saw in Chapter 7, governments routinely intervene in international trade, creating tariff and nontariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the same product in different countries, which is required for the law of one price to hold. Government intervention in cross-border trade, by violating the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory.
PPP theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations.14 In fact, this situation seems to prevail in a number of industries. In the detergent industry, two companies, Unilever and Procter & Gamble, dominate the market in nation after nation. In heavy earthmoving equipment, Caterpillar Inc. and Komatsu are global market leaders. In the market for semiconductor equipment, Applied Materials has a commanding market share lead in almost every important national market. Microsoft dominates the market for personal computer operating systems and applications systems around the world, and so on. In such cases, dominant enterprises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions. This is referred to as price discrimination. For price discrimination to work, arbitrage must be limited. According to this argument, enterprises with some market power may be able to control distribution channels and therefore limit the unauthorized resale (arbitrage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as design or packaging.
For example, even though the version of Microsoft Office sold in China may be less expensive than the version sold in the United States, the use of arbitrage to equalize prices may be limited because few Americans would want a version that was based on Chinese characters. The design differentiation between Microsoft Office for China and for the United States means that the law of one price would not work for Microsoft Office, even if transportation costs were trivial and tariff barriers between the United States and China did not exist. If the inability to practice arbitrage were widespread enough, it would break the connection between changes in relative prices and exchange rates predicted by the PPP theorem and help explain the limited empirical support for this theory.
Another factor of some importance is that governments also intervene in the foreign exchange market in attempting to influence the value of their currencies. We will look at why and how they do this in Chapter 11. For now, the important thing to note is that governments regularly intervene in the foreign exchange market, and this further weakens the link between price changes and changes in exchange rates. One more factor explaining the failure of PPP theory to predict short-term movements in foreign exchange rates is the impact of investor psychology and other factors on currency purchasing decisions and exchange rate movements. We will discuss this issue in more detail later in this chapter.