Explaining the Problems with PPP
What explains the negative empirical results described in the previous section? There are
several immediate problems with our rationale for the PPP theory of exchange rates,
which was based on the law of one price:
1. Contrary to the assumption of the law of one price, transport costs and restrictions
on trade certainly do exist. These trade barriers may be high enough to prevent
some goods and services from being traded between countries.
PJ /PUS
E¥/$
80
100
120
140
160
180
200
220
240
260
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Exchange rate (E¥/$),
Japan-U.S. price level ratio (PJ /PUS)
Figure 16-2
The Yen/Dollar Exchange Rate and Relative Japan–U.S. Price Levels, 1980–2009
The graph shows that relative PPP does not explain the yen/dollar exchange rate during 1980–2009.
Source: IMF, International Financial Statistics. Exchange rates and price levels are end-of-year data.
9 See Paul R. Krugman, “Purchasing Power Parity and Exchange Rates: Another Look at the Evidence,” Journal
of International Economics 8 (August 1978), pp. 397–407; Paul De Grauwe, Marc Janssens, and Hilde Leliaert, Real-
Exchange-Rate Variability from 1920 to 1926 and 1973 to 1982, Princeton Studies in International Finance 56
(International Finance Section, Department of Economics, Princeton University, September 1985); and Hans Genberg,
“Purchasing Power Parity Under Fixed and Flexible Exchange Rates,” Journal of International Economics 8
(May 1978), pp. 247–276.
396 PART THREE Exchange Rates and Open-Economy Macroeconomics
2. Monopolistic or oligopolistic practices in goods markets may interact with transport
costs and other trade barriers to weaken further the link between the prices of
similar goods sold in different countries.
3. Because the inflation data reported in different countries are based on different
commodity baskets, there is no reason for exchange rate changes to offset official
measures of inflation differences, even when there are no barriers to trade and all
products are tradable.
Trade Barriers and Nontradables
Transport costs and governmental trade restrictions make it expensive to move goods
between markets located in different countries and therefore weaken the law of one price
mechanism underlying PPP. Suppose once again that the same sweater sells for in
New York and for £30 in London, but that it costs to ship a sweater between the two
cities. At an exchange rate of per pound, the dollar price of a London sweater is
but an American importer would have to pay
to purchase the sweater in London and get it to New York. At an
exchange rate of per pound, it therefore would not pay to ship sweaters from
London to New York even though their dollar price would be higher in the latter location.
Similarly, at an exchange rate of per pound, an American exporter would lose
money by shipping sweaters from New York to London even though the New York price
of would then be below the dollar price of the sweater in London, .
The lesson of this example is that transport costs sever the close link between exchange
rates and goods prices implied by the law of one price. The greater the transport costs, the
greater the range over which the exchange rate can move, given goods prices in different
countries. Official trade restrictions such as tariffs have a similar effect, because a fee paid
to the customs inspector affects the importer’s profit in the same way as an equivalent
shipping fee. Either type of trade impediment weakens the basis of PPP by allowing the
purchasing power of a given currency to differ more widely from country to country. For
example, in the presence of trade impediments, a dollar need not go as far in London as in
Chicago—and it doesn’t, as anyone who has ever been to London has found out.
As you will recall from Chapter 3, transport costs may be so large relative to the cost of
producing some goods and services that they can never be traded internationally at a profit.
Such goods and services are called nontradables. The time-honored classroom example of
a nontradable is the haircut. A Frenchman desiring an American haircut would have to
transport himself to the United States or transport an American barber to France; in either
case, the cost of transport is so large relative to the price of the service being purchased
that (tourists excepted) French haircuts are consumed only by residents of France while
American haircuts are consumed only by residents of the United States.
The existence in all countries of nontraded goods and services, whose prices are not
linked internationally, allows systematic deviations even from relative PPP. Because the
price of a nontradable is determined entirely by its domestic supply and demand curves,
shifts in those curves may cause the domestic price of a broad commodity basket to change
relative to the foreign price of the same basket. Other things equal, a rise in the price of a
country’s nontradables will raise its price level relative to foreign price levels (measuring all
countries’ price levels in terms of a single currency). Looked at another way, the purchasing
power of any given currency will fall in countries where the prices of nontradables rise.
Each country’s price level includes a wide variety of nontradables, including (along
with haircuts) routine medical treatment, dance instruction, and housing, among others.
Broadly speaking, we can identify traded goods with manufactured products, raw materials,
and agricultural products. Nontradables are primarily services and the outputs of the
$45 $46.50
$1.55
$1.45
$43.50 + $2 = $45.50
1$1.45 per pound2 * 1£302 = $43.50,
$1.45
$2
$45
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 397
construction industry. There are, naturally, exceptions to this rule. For example, financial
services provided by banks and brokerage houses often can be traded internationally. (The
rise of the Internet, in particular, has expanded the range of tradable services.) In addition,
trade restrictions, if sufficiently severe, can cause goods that would normally be traded to
become nontraded. Thus, in most countries, some manufactures are nontraded.
We can get a very rough idea of the importance of nontradables in the American economy
by looking at the contribution of the service and construction industries to U.S. GNP.
In 2009, the output of these industries accounted for about 51 percent of U.S. GNP.
Numbers like these are likely to understate the importance of nontradables in determining
national price levels. Even the prices of tradable products usually include costs of nontraded
distribution and marketing services that bring goods from producers to consumers.
(See “Some Meaty Evidence on the Law of One Price,” pages 398–400.) Nontradables
help explain the wide departures from relative PPP illustrated by Figure 16-2.
Departures from Free Competition
When trade barriers and imperfectly competitive market structures occur together, linkages
between national price levels are weakened further. An extreme case occurs when a
single firm sells a commodity for different prices in different markets.
When a firm sells the same product for different prices in different markets, we say that
it is practicing pricing to market. Pricing to market may reflect different demand conditions
in different countries. For example, countries where demand is more price-inelastic
will tend to be charged higher markups over a monopolistic seller’s production cost.
Empirical studies of firm-level export data have yielded strong evidence of pervasive pricing
to market in manufacturing trade.10
In 2007, for example, a Ford Focus cost more in Germany than in Finland despite
those countries’ shared currency (the euro) and despite the European Union’s efforts over
many years to remove intra-European trade barriers (see Chapter 20). Such price differentials
would be difficult to enforce if it were not costly for consumers to buy autos in Finland
and drive or ship them to Germany, or if consumers viewed cheaper cars available in
Germany as good substitutes for the Focus. The combination of product differentiation and
segmented markets, however, leads to large violations of the law of one price and absolute
PPP. Shifts in market structure and demand over time can invalidate relative PPP.
Differences in Consumption Patterns
and Price Level Measurement
Government measures of the price level differ from country to country. One reason for these
differences is that people living in different countries spend their incomes in different ways.
In general, people consume relatively higher proportions of their own country’s products—
including its tradable products—than of foreign-made products. The average Norwegian
consumes more reindeer meat than her American counterpart, the average Japanese more
sushi, and the average Indian more chutney. In constructing a reference commodity basket to
measure purchasing power, it is therefore likely that the Norwegian government will put a
$5,000
10For a detailed review of the evidence, see the paper by Goldberg and Knetter in this chapter’s Further
Readings. Theoretical contributions on pricing to market include Rudiger Dornbusch, “Exchange Rates and
Prices,” American Economic Review 77 (March 1987), pp. 93–106; Paul R. Krugman, “Pricing to Market When
the Exchange Rate Changes,” in Sven W. Arndt and J. David Richardson, eds., Real-Financial Linkages among
Open Economies (Cambridge, MA: MIT Press, 1987); and Andrew Atkeson and Ariel Burstein, “Pricingto-
Market, Trade Costs, and International Relative Prices,” American Economic Review 98 (December 2008),
pp. 1998–2031.
398 PART THREE Exchange Rates and Open-Economy Macroeconomics
In the summer of 1986 the Economist magazine conducted
an extensive survey on the prices of Big Mac
hamburgers at McDonald’s restaurants throughout
the world. This apparently whimsical undertaking
was not the result of an outbreak
of editorial giddiness. Rather,
the magazine wanted to poke fun
at economists who confidently
declare exchange rates to be
“overvalued” or “undervalued”
on the basis of PPP comparisons.
Since Big Macs are “sold
in 41 countries, with only the
most trivial changes of recipe,”
the magazine argued, a comparison
of hamburger prices should
serve as a “medium-rare guide to
whether currencies are trading at
the right exchange rates.”* Since
1986, the Economist has periodically
updated its calculations.
One way of interpreting the Economist survey is
as a test of the law of one price. Viewed in this way,
the results of the initial test were quite startling.
The dollar prices of Big Macs turned out to be
wildly different in different countries. For example,
the price of a Big Mac in New York was 50 percent
higher than in Australia and 64 percent higher than
in Hong Kong. In contrast, a Parisian Big Mac cost
54 percent more than its New York counterpart, and
a Tokyo Big Mac cost 50 percent more. Only in
Britain and Ireland were the dollar prices of the
burgers close to New York levels.
How can this dramatic violation of the law of
one price be explained? As the Economist noted,
transport costs and government regulations are
part of the explanation. Product differentiation is
probably an important additional factor. Because
relatively few close substitutes for Big Macs are
available in some countries, product differentiation
may give McDonald’s some power to tailor
prices to the local market. Finally, remember that
the price of a Big Mac must cover not only the
cost of ground meat and buns, but also the wages
of serving people, rent, electricity, and so on. The
prices of these nonfood inputs can differ sharply
in different countries.
We have reproduced the results of the
Economist’s January 2009 survey
report. The table on the following
page shows various
countries’ prices of Big Macs,
measured in U.S. dollar terms.
These range from a high of
in Norway (63.5 percent
above the U.S. price) to only
$1.52 in Malaysia (less than half
the U.S. price).
For each country, we can figure
out a “Big Mac PPP,” which
is the hypothetical level of the
exchange rate that would equate
the dollar price of a locally sold
Big Mac to its U.S. price.
For example, in January 2009, a
Norwegian krone cost about in the foreign
exchange market. The exchange rate that would
have equalized U.S. and Norwegian burger prices,
however, was
or 11.3 kroner per U.S. dollar.
It is often said that a currency is overvalued when
its exchange rate makes domestic goods expensive
relative to similar goods sold abroad and undervalued
in the opposite case. For the Norwegian krone,
for example, the degree of overvaluation on the Big
Mac scale is the percentage by which the market
dollar price of a krone exceeds the hypothetical Big
Mac PPP rate, or
Of course, this is exactly the percentage by which
the dollar price of a Norwegian burger exceeds that
of a U.S. burger.
100 * 10.1447 - 0.08852/0.0885 = 63.5 percent.
= 0.0885 dollars per krone,
* 13.54 dollars per burger/5.79 dollars per burger2
(0.1447 dollars per krone)
$0.1447
$3.54
$5.79
Some Meaty Evidence on the Law of One Price
*“On the Hamburger Standard,” Economist, September 6–12, 1986.
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 399
The hamburger standard
Big Mac prices Implied
PPP*
of the dollar
Actual
exchange
rate: Jan 30th
Under (-)/over(+)
Valuation against
the dollar,%
in local
currency
in
dollars
United States† $3.54 3.54 - -
Argentina Peso 11.50 3.30 3.25 3.49 -7
Australia A$3.45 2.19 0.97 1.57 -38
Brazil Real 8.02 3.45 2.27 2.32 -2
Britain £2.29 3.30 1.55‡ 1.44‡ -7
Canada C$4.16 3.36 1.18 1.24 -5
Chile Peso 1.550 2.51 438 617 -29
China Yuan 12.5 1.83 3.53 6.84 -48
Czech Republic Koruna 65.94 3.02 18.6 21.9 -15
Denmark DK 29.5 5.07 8.33 5.82 43
Egypt
Euro areas§
Pound 13.0 2.34 3.67 5.57 -34
€3.42 4.38 1.04** 1.28** 24
Hong Kong HK$13.3 1.72 3.76 7.75 -52
Hungary Forint 680 2.92 192 233 -18
Indonesia Rupiah 19.800 1.74 5,593 11,380 -51
Israel Shekel 15.0 3.69 4.24 4.07 4
Japan ¥290 3.23 81.9 89.8 -9
Malaysia Ringgit 5.50 1.52 1.55 3.61 -57
Mexico Peso 33.0 2.30 9.32 14.4 -35
New Zealand NZ$4.90 2.48 1.38 1.97 -30
Norway Kroner 40.0 5.79 11.3 6.61 63
Peru Sol 8.06 2.54 2.28 3.18 -28
Philippines Peso 98.0 2.07 27.7 47.4 -42
Poland Zloty 7.00 2.01 1.98 3.48 -43
Russia Ruble 62.0 1.73 17.5 35.7 -51
Saudi Arabia Riyal 10.0 2.66 2.82 3.75 -25
Singapore S$3.95 2.61 1.12 1.51 -26
South Africa Rand 16.95 1.66 4.79 10.2 -53
South Korea Won 3,300 2.39 932 1,380 -32
Sweden SKR 38.0 4.58 10.7 8.30 29
Switzerland CHF 6.50 5.60 1.84 1.16 58
Taiwan NT$75.0 2.23 21.2 33.6 -37
Thailand Baht 62.0 1.77 17.5 35.0 -50
Turkey Lire 5.15 3.13 1.45 1.64 -12
*Purchasing power parity: local price divided by price in United States; †Average of New York, Atlanta, Chicago, and San
Francisco; ‡Dollars per pound; §Weighted average of prices in euro area; **Dollars per euro
Sources: McDonald’s; the Economist, February 4, 2010. Exchange rates are local currency per dollar, except where noted.
400 PART THREE Exchange Rates and Open-Economy Macroeconomics
relatively high weight on reindeer, the Japanese government a high weight on sushi, and the
Indian government a high weight on chutney.
Because relative PPP makes predictions about price changes rather than price levels, it
is a sensible concept regardless of the baskets used to define price levels in the countries
being compared. If all U.S. prices increase by 10 percent and the dollar depreciates against
foreign currencies by 10 percent, relative PPP will be satisfied (assuming there are no
changes abroad) for any domestic and foreign choices of price level indexes.
Change in the relative prices of basket components, however, can cause relative PPP to
fail tests that are based on official price indexes. For example, a rise in the relative price of
fish would raise the dollar price of a Japanese government reference commodity basket
relative to that of a U.S. government basket, simply because fish takes up a larger share of
the Japanese basket. Relative price changes could lead to PPP violations like those shown
in Figure 16-2 even if trade were free and costless.
PPP in the Short Run and in the Long Run
The factors we have examined so far in explaining the PPP theory’s poor empirical performance
can cause national price levels to diverge even in the long run, after all prices
have had time to adjust to their market-clearing levels. As we discussed in Chapter 15,
however, many prices in the economy are sticky and take time to adjust fully. Departures
from PPP may therefore be even greater in the short run than in the long run.
An abrupt depreciation of the dollar against foreign currencies, for example, makes
farm equipment in the United States cheaper relative to similar equipment produced
abroad. As farmers throughout the world shift their demand for tractors and reapers to
Likewise, in January 2009 the dollar price of the
Chinese renminbi was 48 percent below the level
needed to bring about burger price parity: That
country’s currency was undervalued by 48 percent,
according to the Big Mac measure. China’s currency
would have had to appreciate substantially
against the dollar to bring the Chinese and U.S.
prices of Big Macs into line. Norway’s currency,
in contrast, would have had to depreciate substantially.
In general, a “PPP exchange rate” is defined as
one that equates the international prices of some
broad basket of goods and services, not just hamburgers.
As we shall see, there are several reasons why we
might expect PPP not to hold exactly, even over long
periods. Thus, despite the widespread use of terms
like overvaluation, policy makers have to be very
cautious in judging whether any particular level of
the exchange rate may signal the need for economic
policy changes.
Policy makers would be wise, however, to take
into account extremes of over- or undervaluation.
Consider the case of Iceland. In January 2006,
Iceland had a dollar Big Mac price of and a
whopping 131 percent currency overvaluation on
the Big Mac scale. Then the tiny country was
swept up in a global financial crisis that we will
discuss in detail in Chapters 19 and 21. From
around 68 kronur per dollar in 2006, the currency
depreciated all the way to around 120 per dollar
by 2010. Unlike many other countries, Iceland
imports the burgers’ ingredients, the kronur
prices of which rose sharply because of the depreciation.
The sudden cost increase made the franchise
unprofitable without a big rise in prices to
customers. But Iceland’s economy had suffered
severely in the crisis. Rather than boosting prices,
the franchise owner closed all three of Iceland’s
McDonald’s restaurants. As a result, the country
no longer appears in the Economist’s survey.†
$7.44
†See Omar R. Valdimarsson, “McDonald’s Closes in Iceland after Krona Collapse,” Bloomberg News, October 26, 2009.
Available at http://www.bloomberg.com/apps/ news?pid=newsarchive&sid=amu4.WTVaqjI
U.S. producers, the price of American farm equipment tends to rise to reduce the divergence
from the law of one price caused by the dollar’s depreciation. It takes time for
this process of price increase to be complete, however, and prices for U.S. and foreign
farm equipment may differ considerably while markets adjust to the exchange rate
change.
You might suspect that short-run price stickiness and exchange rate volatility help
explain a phenomenon we noted in discussing Figure 16-2—that violations of relative PPP
have been much more flagrant over periods when exchange rates have floated. Empirical
research supports this interpretation of the data. Figure 15-11, which we used to illustrate
the stickiness of goods prices compared with exchange rates, is quite typical of floatingrate
episodes. In a careful study covering many countries and historical episodes, economist
Michael Mussa of the Peterson Institute for International Economics compared the
extent of short-run deviations from PPP under fixed and floating exchange rates. He found
that floating exchange rates systematically lead to much larger and more frequent shortrun
deviations from relative PPP.11 The box on pages 406–407 provides an especially
vivid illustration of how price stickiness can generate violations of the law of one price
even for absolutely identical goods.
Recent research suggests that short-run deviations from PPP such as those due to
volatile exchange rates die away over time, with only half the effect of a temporary departure
from PPP remaining after four years.12 Even when these temporary PPP deviations
are removed from the data, however, it still appears that the cumulative effect of certain
long-run trends causes predictable departures from PPP for many countries. The Case
Study entitled “Why Price Levels Are Lower in Poorer Countries” discusses one of the
major mechanisms behind such trends.
Case Study
Why Price Levels Are Lower in Poorer Countries
Research on international price level differences has uncovered a striking empirical
regularity: When expressed in terms of a single currency, countries’ price levels are
positively related to the level of real income per capita. In other words, a dollar, when
converted to local currency at the market exchange rate, generally goes much further in
a poor country than in a rich one. Figure 16-3 illustrates the relation between price
levels and income, with each dot representing a different country.
The previous section’s discussion of the role of nontraded goods in the determination
of national price levels suggests that international variations in the prices of nontradables
may contribute to price level discrepancies between rich and poor nations.
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 401
11See Mussa, “Nominal Exchange Rate Regimes and the Behavior of Real Exchange Rates: Evidence and
Implications,” in Karl Brunner and Allan H. Meltzer, eds., Real Business Cycles, Real Exchange Rates and
Actual Policies, Carnegie-Rochester Conference Series on Public Policy 25 (Amsterdam: North-Holland, 1986),
pp. 117–214. Charles Engel of the University of Wisconsin has found that under a floating exchange rate, international
price differences for the same good can be more variable than the relative price of different goods within
a single country. See Engel, “Real Exchange Rates and Relative Prices: An Empirical Investigation,” Journal of
Monetary Economics 32 (August 1993), pp. 35–50.
12See, for example, Jeffrey A. Frankel and Andrew K. Rose, “A Panel Project on Purchasing Power Parity: Mean
Reversion Within and Between Countries,” Journal of International Economics 40 (February 1996), pp. 209–224.
The statistical validity of these results is challenged by Paul G. J. O’Connell in “The Overvaluation of Purchasing
Power Parity,” Journal of International Economics 44 (February 1998), pp. 1–19.
402 PART THREE Exchange Rates and Open-Economy Macroeconomics
0
20
40
60
80
100
120
140
160
0 10,000 20,000 30,000 40,000 50,000 60,000
Real per capita income
(in 2000 U.S. dollars)
Price level relative to U.S. (U.S. = 100)
13See Balassa, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political Economy 72
(December 1964), pp. 584–596; and Samuelson, “Theoretical Notes on Trade Problems,” Review of Economics
and Statistics 46 (May 1964), pp. 145–154. The Balassa-Samuelson theory was foreshadowed by some observations
of Ricardo. See Jacob Viner, Studies in the Theory of International Trade (New York: Harper & Brothers,
1937), p. 315.
The available data indeed show that nontradables tend to be more expensive (relative to
tradables) in richer countries.
One reason for the lower relative price of nontradables in poor countries was suggested
by Bela Balassa and Paul Samuelson.13 The Balassa-Samuelson theory assumes
that the labor forces of poor countries are less productive than those of rich countries in
the tradables sector but that international productivity differences in nontradables are
negligible. If the prices of traded goods are roughly equal in all countries, however,
lower labor productivity in the tradables industries of poor countries implies lower
wages than abroad, lower production costs in nontradables, and therefore a lower price
of nontradables. Rich countries with higher labor productivity in the tradables sector
will tend to have higher nontradables prices and higher price levels. Productivity statistics
give some empirical support to the Balassa-Samuelson differential productivity
postulate. And it is plausible that international productivity differences are
sharper in traded than in nontraded goods. Whether a country is rich or poor, a barber
Figure 16-3
Price Levels and Real Incomes, 2007
Countries’ price levels tend to rise as their real incomes rise. Each dot represents a country.
The straight line indicates a statistician’s best prediction of a country’s price level relative to
that of the United States based on knowing its real per capita income.
Source: Penn World Table, version 6.3.
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 403
can give only so many haircuts in a week, but there may be a significant scope for
productivity differences across countries in the manufacture of traded goods like
personal computers.
An alternative theory that attempts to explain the lower price levels of poor countries
was put forth by Jagdish Bhagwati of Columbia University, and by Irving Kravis
of the University of Pennsylvania and Robert Lipsey of the City University of New
York.14 The Bhagwati-Kravis-Lipsey view relies on differences in endowments of
capital and labor rather than productivity differences, but it also predicts that the relative
price of nontradables increases as real per capita income increases. Rich countries
have high capital-labor ratios, while poor countries have more labor relative to capital.
Because rich countries have higher capital-labor ratios, the marginal productivity of
labor is greater in rich countries than in poor countries, and the former will therefore
have a higher wage level than the latter.15 Nontradables, which consist largely of
services, are naturally labor-intensive relative to tradables. Because labor is cheaper in
poor countries and is used intensively in producing nontradables, nontradables also
will be cheaper there than in the rich, high-wage countries. Once again, this international
difference in the relative price of nontradables suggests that overall price levels,
when measured in a single currency, should be higher in rich countries than in poor
countries.
What explains the negative empirical results described in the previous section? There are
several immediate problems with our rationale for the PPP theory of exchange rates,
which was based on the law of one price:
1. Contrary to the assumption of the law of one price, transport costs and restrictions
on trade certainly do exist. These trade barriers may be high enough to prevent
some goods and services from being traded between countries.
PJ /PUS
E¥/$
80
100
120
140
160
180
200
220
240
260
1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008
Exchange rate (E¥/$),
Japan-U.S. price level ratio (PJ /PUS)
Figure 16-2
The Yen/Dollar Exchange Rate and Relative Japan–U.S. Price Levels, 1980–2009
The graph shows that relative PPP does not explain the yen/dollar exchange rate during 1980–2009.
Source: IMF, International Financial Statistics. Exchange rates and price levels are end-of-year data.
9 See Paul R. Krugman, “Purchasing Power Parity and Exchange Rates: Another Look at the Evidence,” Journal
of International Economics 8 (August 1978), pp. 397–407; Paul De Grauwe, Marc Janssens, and Hilde Leliaert, Real-
Exchange-Rate Variability from 1920 to 1926 and 1973 to 1982, Princeton Studies in International Finance 56
(International Finance Section, Department of Economics, Princeton University, September 1985); and Hans Genberg,
“Purchasing Power Parity Under Fixed and Flexible Exchange Rates,” Journal of International Economics 8
(May 1978), pp. 247–276.
396 PART THREE Exchange Rates and Open-Economy Macroeconomics
2. Monopolistic or oligopolistic practices in goods markets may interact with transport
costs and other trade barriers to weaken further the link between the prices of
similar goods sold in different countries.
3. Because the inflation data reported in different countries are based on different
commodity baskets, there is no reason for exchange rate changes to offset official
measures of inflation differences, even when there are no barriers to trade and all
products are tradable.
Trade Barriers and Nontradables
Transport costs and governmental trade restrictions make it expensive to move goods
between markets located in different countries and therefore weaken the law of one price
mechanism underlying PPP. Suppose once again that the same sweater sells for in
New York and for £30 in London, but that it costs to ship a sweater between the two
cities. At an exchange rate of per pound, the dollar price of a London sweater is
but an American importer would have to pay
to purchase the sweater in London and get it to New York. At an
exchange rate of per pound, it therefore would not pay to ship sweaters from
London to New York even though their dollar price would be higher in the latter location.
Similarly, at an exchange rate of per pound, an American exporter would lose
money by shipping sweaters from New York to London even though the New York price
of would then be below the dollar price of the sweater in London, .
The lesson of this example is that transport costs sever the close link between exchange
rates and goods prices implied by the law of one price. The greater the transport costs, the
greater the range over which the exchange rate can move, given goods prices in different
countries. Official trade restrictions such as tariffs have a similar effect, because a fee paid
to the customs inspector affects the importer’s profit in the same way as an equivalent
shipping fee. Either type of trade impediment weakens the basis of PPP by allowing the
purchasing power of a given currency to differ more widely from country to country. For
example, in the presence of trade impediments, a dollar need not go as far in London as in
Chicago—and it doesn’t, as anyone who has ever been to London has found out.
As you will recall from Chapter 3, transport costs may be so large relative to the cost of
producing some goods and services that they can never be traded internationally at a profit.
Such goods and services are called nontradables. The time-honored classroom example of
a nontradable is the haircut. A Frenchman desiring an American haircut would have to
transport himself to the United States or transport an American barber to France; in either
case, the cost of transport is so large relative to the price of the service being purchased
that (tourists excepted) French haircuts are consumed only by residents of France while
American haircuts are consumed only by residents of the United States.
The existence in all countries of nontraded goods and services, whose prices are not
linked internationally, allows systematic deviations even from relative PPP. Because the
price of a nontradable is determined entirely by its domestic supply and demand curves,
shifts in those curves may cause the domestic price of a broad commodity basket to change
relative to the foreign price of the same basket. Other things equal, a rise in the price of a
country’s nontradables will raise its price level relative to foreign price levels (measuring all
countries’ price levels in terms of a single currency). Looked at another way, the purchasing
power of any given currency will fall in countries where the prices of nontradables rise.
Each country’s price level includes a wide variety of nontradables, including (along
with haircuts) routine medical treatment, dance instruction, and housing, among others.
Broadly speaking, we can identify traded goods with manufactured products, raw materials,
and agricultural products. Nontradables are primarily services and the outputs of the
$45 $46.50
$1.55
$1.45
$43.50 + $2 = $45.50
1$1.45 per pound2 * 1£302 = $43.50,
$1.45
$2
$45
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 397
construction industry. There are, naturally, exceptions to this rule. For example, financial
services provided by banks and brokerage houses often can be traded internationally. (The
rise of the Internet, in particular, has expanded the range of tradable services.) In addition,
trade restrictions, if sufficiently severe, can cause goods that would normally be traded to
become nontraded. Thus, in most countries, some manufactures are nontraded.
We can get a very rough idea of the importance of nontradables in the American economy
by looking at the contribution of the service and construction industries to U.S. GNP.
In 2009, the output of these industries accounted for about 51 percent of U.S. GNP.
Numbers like these are likely to understate the importance of nontradables in determining
national price levels. Even the prices of tradable products usually include costs of nontraded
distribution and marketing services that bring goods from producers to consumers.
(See “Some Meaty Evidence on the Law of One Price,” pages 398–400.) Nontradables
help explain the wide departures from relative PPP illustrated by Figure 16-2.
Departures from Free Competition
When trade barriers and imperfectly competitive market structures occur together, linkages
between national price levels are weakened further. An extreme case occurs when a
single firm sells a commodity for different prices in different markets.
When a firm sells the same product for different prices in different markets, we say that
it is practicing pricing to market. Pricing to market may reflect different demand conditions
in different countries. For example, countries where demand is more price-inelastic
will tend to be charged higher markups over a monopolistic seller’s production cost.
Empirical studies of firm-level export data have yielded strong evidence of pervasive pricing
to market in manufacturing trade.10
In 2007, for example, a Ford Focus cost more in Germany than in Finland despite
those countries’ shared currency (the euro) and despite the European Union’s efforts over
many years to remove intra-European trade barriers (see Chapter 20). Such price differentials
would be difficult to enforce if it were not costly for consumers to buy autos in Finland
and drive or ship them to Germany, or if consumers viewed cheaper cars available in
Germany as good substitutes for the Focus. The combination of product differentiation and
segmented markets, however, leads to large violations of the law of one price and absolute
PPP. Shifts in market structure and demand over time can invalidate relative PPP.
Differences in Consumption Patterns
and Price Level Measurement
Government measures of the price level differ from country to country. One reason for these
differences is that people living in different countries spend their incomes in different ways.
In general, people consume relatively higher proportions of their own country’s products—
including its tradable products—than of foreign-made products. The average Norwegian
consumes more reindeer meat than her American counterpart, the average Japanese more
sushi, and the average Indian more chutney. In constructing a reference commodity basket to
measure purchasing power, it is therefore likely that the Norwegian government will put a
$5,000
10For a detailed review of the evidence, see the paper by Goldberg and Knetter in this chapter’s Further
Readings. Theoretical contributions on pricing to market include Rudiger Dornbusch, “Exchange Rates and
Prices,” American Economic Review 77 (March 1987), pp. 93–106; Paul R. Krugman, “Pricing to Market When
the Exchange Rate Changes,” in Sven W. Arndt and J. David Richardson, eds., Real-Financial Linkages among
Open Economies (Cambridge, MA: MIT Press, 1987); and Andrew Atkeson and Ariel Burstein, “Pricingto-
Market, Trade Costs, and International Relative Prices,” American Economic Review 98 (December 2008),
pp. 1998–2031.
398 PART THREE Exchange Rates and Open-Economy Macroeconomics
In the summer of 1986 the Economist magazine conducted
an extensive survey on the prices of Big Mac
hamburgers at McDonald’s restaurants throughout
the world. This apparently whimsical undertaking
was not the result of an outbreak
of editorial giddiness. Rather,
the magazine wanted to poke fun
at economists who confidently
declare exchange rates to be
“overvalued” or “undervalued”
on the basis of PPP comparisons.
Since Big Macs are “sold
in 41 countries, with only the
most trivial changes of recipe,”
the magazine argued, a comparison
of hamburger prices should
serve as a “medium-rare guide to
whether currencies are trading at
the right exchange rates.”* Since
1986, the Economist has periodically
updated its calculations.
One way of interpreting the Economist survey is
as a test of the law of one price. Viewed in this way,
the results of the initial test were quite startling.
The dollar prices of Big Macs turned out to be
wildly different in different countries. For example,
the price of a Big Mac in New York was 50 percent
higher than in Australia and 64 percent higher than
in Hong Kong. In contrast, a Parisian Big Mac cost
54 percent more than its New York counterpart, and
a Tokyo Big Mac cost 50 percent more. Only in
Britain and Ireland were the dollar prices of the
burgers close to New York levels.
How can this dramatic violation of the law of
one price be explained? As the Economist noted,
transport costs and government regulations are
part of the explanation. Product differentiation is
probably an important additional factor. Because
relatively few close substitutes for Big Macs are
available in some countries, product differentiation
may give McDonald’s some power to tailor
prices to the local market. Finally, remember that
the price of a Big Mac must cover not only the
cost of ground meat and buns, but also the wages
of serving people, rent, electricity, and so on. The
prices of these nonfood inputs can differ sharply
in different countries.
We have reproduced the results of the
Economist’s January 2009 survey
report. The table on the following
page shows various
countries’ prices of Big Macs,
measured in U.S. dollar terms.
These range from a high of
in Norway (63.5 percent
above the U.S. price) to only
$1.52 in Malaysia (less than half
the U.S. price).
For each country, we can figure
out a “Big Mac PPP,” which
is the hypothetical level of the
exchange rate that would equate
the dollar price of a locally sold
Big Mac to its U.S. price.
For example, in January 2009, a
Norwegian krone cost about in the foreign
exchange market. The exchange rate that would
have equalized U.S. and Norwegian burger prices,
however, was
or 11.3 kroner per U.S. dollar.
It is often said that a currency is overvalued when
its exchange rate makes domestic goods expensive
relative to similar goods sold abroad and undervalued
in the opposite case. For the Norwegian krone,
for example, the degree of overvaluation on the Big
Mac scale is the percentage by which the market
dollar price of a krone exceeds the hypothetical Big
Mac PPP rate, or
Of course, this is exactly the percentage by which
the dollar price of a Norwegian burger exceeds that
of a U.S. burger.
100 * 10.1447 - 0.08852/0.0885 = 63.5 percent.
= 0.0885 dollars per krone,
* 13.54 dollars per burger/5.79 dollars per burger2
(0.1447 dollars per krone)
$0.1447
$3.54
$5.79
Some Meaty Evidence on the Law of One Price
*“On the Hamburger Standard,” Economist, September 6–12, 1986.
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 399
The hamburger standard
Big Mac prices Implied
PPP*
of the dollar
Actual
exchange
rate: Jan 30th
Under (-)/over(+)
Valuation against
the dollar,%
in local
currency
in
dollars
United States† $3.54 3.54 - -
Argentina Peso 11.50 3.30 3.25 3.49 -7
Australia A$3.45 2.19 0.97 1.57 -38
Brazil Real 8.02 3.45 2.27 2.32 -2
Britain £2.29 3.30 1.55‡ 1.44‡ -7
Canada C$4.16 3.36 1.18 1.24 -5
Chile Peso 1.550 2.51 438 617 -29
China Yuan 12.5 1.83 3.53 6.84 -48
Czech Republic Koruna 65.94 3.02 18.6 21.9 -15
Denmark DK 29.5 5.07 8.33 5.82 43
Egypt
Euro areas§
Pound 13.0 2.34 3.67 5.57 -34
€3.42 4.38 1.04** 1.28** 24
Hong Kong HK$13.3 1.72 3.76 7.75 -52
Hungary Forint 680 2.92 192 233 -18
Indonesia Rupiah 19.800 1.74 5,593 11,380 -51
Israel Shekel 15.0 3.69 4.24 4.07 4
Japan ¥290 3.23 81.9 89.8 -9
Malaysia Ringgit 5.50 1.52 1.55 3.61 -57
Mexico Peso 33.0 2.30 9.32 14.4 -35
New Zealand NZ$4.90 2.48 1.38 1.97 -30
Norway Kroner 40.0 5.79 11.3 6.61 63
Peru Sol 8.06 2.54 2.28 3.18 -28
Philippines Peso 98.0 2.07 27.7 47.4 -42
Poland Zloty 7.00 2.01 1.98 3.48 -43
Russia Ruble 62.0 1.73 17.5 35.7 -51
Saudi Arabia Riyal 10.0 2.66 2.82 3.75 -25
Singapore S$3.95 2.61 1.12 1.51 -26
South Africa Rand 16.95 1.66 4.79 10.2 -53
South Korea Won 3,300 2.39 932 1,380 -32
Sweden SKR 38.0 4.58 10.7 8.30 29
Switzerland CHF 6.50 5.60 1.84 1.16 58
Taiwan NT$75.0 2.23 21.2 33.6 -37
Thailand Baht 62.0 1.77 17.5 35.0 -50
Turkey Lire 5.15 3.13 1.45 1.64 -12
*Purchasing power parity: local price divided by price in United States; †Average of New York, Atlanta, Chicago, and San
Francisco; ‡Dollars per pound; §Weighted average of prices in euro area; **Dollars per euro
Sources: McDonald’s; the Economist, February 4, 2010. Exchange rates are local currency per dollar, except where noted.
400 PART THREE Exchange Rates and Open-Economy Macroeconomics
relatively high weight on reindeer, the Japanese government a high weight on sushi, and the
Indian government a high weight on chutney.
Because relative PPP makes predictions about price changes rather than price levels, it
is a sensible concept regardless of the baskets used to define price levels in the countries
being compared. If all U.S. prices increase by 10 percent and the dollar depreciates against
foreign currencies by 10 percent, relative PPP will be satisfied (assuming there are no
changes abroad) for any domestic and foreign choices of price level indexes.
Change in the relative prices of basket components, however, can cause relative PPP to
fail tests that are based on official price indexes. For example, a rise in the relative price of
fish would raise the dollar price of a Japanese government reference commodity basket
relative to that of a U.S. government basket, simply because fish takes up a larger share of
the Japanese basket. Relative price changes could lead to PPP violations like those shown
in Figure 16-2 even if trade were free and costless.
PPP in the Short Run and in the Long Run
The factors we have examined so far in explaining the PPP theory’s poor empirical performance
can cause national price levels to diverge even in the long run, after all prices
have had time to adjust to their market-clearing levels. As we discussed in Chapter 15,
however, many prices in the economy are sticky and take time to adjust fully. Departures
from PPP may therefore be even greater in the short run than in the long run.
An abrupt depreciation of the dollar against foreign currencies, for example, makes
farm equipment in the United States cheaper relative to similar equipment produced
abroad. As farmers throughout the world shift their demand for tractors and reapers to
Likewise, in January 2009 the dollar price of the
Chinese renminbi was 48 percent below the level
needed to bring about burger price parity: That
country’s currency was undervalued by 48 percent,
according to the Big Mac measure. China’s currency
would have had to appreciate substantially
against the dollar to bring the Chinese and U.S.
prices of Big Macs into line. Norway’s currency,
in contrast, would have had to depreciate substantially.
In general, a “PPP exchange rate” is defined as
one that equates the international prices of some
broad basket of goods and services, not just hamburgers.
As we shall see, there are several reasons why we
might expect PPP not to hold exactly, even over long
periods. Thus, despite the widespread use of terms
like overvaluation, policy makers have to be very
cautious in judging whether any particular level of
the exchange rate may signal the need for economic
policy changes.
Policy makers would be wise, however, to take
into account extremes of over- or undervaluation.
Consider the case of Iceland. In January 2006,
Iceland had a dollar Big Mac price of and a
whopping 131 percent currency overvaluation on
the Big Mac scale. Then the tiny country was
swept up in a global financial crisis that we will
discuss in detail in Chapters 19 and 21. From
around 68 kronur per dollar in 2006, the currency
depreciated all the way to around 120 per dollar
by 2010. Unlike many other countries, Iceland
imports the burgers’ ingredients, the kronur
prices of which rose sharply because of the depreciation.
The sudden cost increase made the franchise
unprofitable without a big rise in prices to
customers. But Iceland’s economy had suffered
severely in the crisis. Rather than boosting prices,
the franchise owner closed all three of Iceland’s
McDonald’s restaurants. As a result, the country
no longer appears in the Economist’s survey.†
$7.44
†See Omar R. Valdimarsson, “McDonald’s Closes in Iceland after Krona Collapse,” Bloomberg News, October 26, 2009.
Available at http://www.bloomberg.com/apps/ news?pid=newsarchive&sid=amu4.WTVaqjI
U.S. producers, the price of American farm equipment tends to rise to reduce the divergence
from the law of one price caused by the dollar’s depreciation. It takes time for
this process of price increase to be complete, however, and prices for U.S. and foreign
farm equipment may differ considerably while markets adjust to the exchange rate
change.
You might suspect that short-run price stickiness and exchange rate volatility help
explain a phenomenon we noted in discussing Figure 16-2—that violations of relative PPP
have been much more flagrant over periods when exchange rates have floated. Empirical
research supports this interpretation of the data. Figure 15-11, which we used to illustrate
the stickiness of goods prices compared with exchange rates, is quite typical of floatingrate
episodes. In a careful study covering many countries and historical episodes, economist
Michael Mussa of the Peterson Institute for International Economics compared the
extent of short-run deviations from PPP under fixed and floating exchange rates. He found
that floating exchange rates systematically lead to much larger and more frequent shortrun
deviations from relative PPP.11 The box on pages 406–407 provides an especially
vivid illustration of how price stickiness can generate violations of the law of one price
even for absolutely identical goods.
Recent research suggests that short-run deviations from PPP such as those due to
volatile exchange rates die away over time, with only half the effect of a temporary departure
from PPP remaining after four years.12 Even when these temporary PPP deviations
are removed from the data, however, it still appears that the cumulative effect of certain
long-run trends causes predictable departures from PPP for many countries. The Case
Study entitled “Why Price Levels Are Lower in Poorer Countries” discusses one of the
major mechanisms behind such trends.
Case Study
Why Price Levels Are Lower in Poorer Countries
Research on international price level differences has uncovered a striking empirical
regularity: When expressed in terms of a single currency, countries’ price levels are
positively related to the level of real income per capita. In other words, a dollar, when
converted to local currency at the market exchange rate, generally goes much further in
a poor country than in a rich one. Figure 16-3 illustrates the relation between price
levels and income, with each dot representing a different country.
The previous section’s discussion of the role of nontraded goods in the determination
of national price levels suggests that international variations in the prices of nontradables
may contribute to price level discrepancies between rich and poor nations.
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 401
11See Mussa, “Nominal Exchange Rate Regimes and the Behavior of Real Exchange Rates: Evidence and
Implications,” in Karl Brunner and Allan H. Meltzer, eds., Real Business Cycles, Real Exchange Rates and
Actual Policies, Carnegie-Rochester Conference Series on Public Policy 25 (Amsterdam: North-Holland, 1986),
pp. 117–214. Charles Engel of the University of Wisconsin has found that under a floating exchange rate, international
price differences for the same good can be more variable than the relative price of different goods within
a single country. See Engel, “Real Exchange Rates and Relative Prices: An Empirical Investigation,” Journal of
Monetary Economics 32 (August 1993), pp. 35–50.
12See, for example, Jeffrey A. Frankel and Andrew K. Rose, “A Panel Project on Purchasing Power Parity: Mean
Reversion Within and Between Countries,” Journal of International Economics 40 (February 1996), pp. 209–224.
The statistical validity of these results is challenged by Paul G. J. O’Connell in “The Overvaluation of Purchasing
Power Parity,” Journal of International Economics 44 (February 1998), pp. 1–19.
402 PART THREE Exchange Rates and Open-Economy Macroeconomics
0
20
40
60
80
100
120
140
160
0 10,000 20,000 30,000 40,000 50,000 60,000
Real per capita income
(in 2000 U.S. dollars)
Price level relative to U.S. (U.S. = 100)
13See Balassa, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political Economy 72
(December 1964), pp. 584–596; and Samuelson, “Theoretical Notes on Trade Problems,” Review of Economics
and Statistics 46 (May 1964), pp. 145–154. The Balassa-Samuelson theory was foreshadowed by some observations
of Ricardo. See Jacob Viner, Studies in the Theory of International Trade (New York: Harper & Brothers,
1937), p. 315.
The available data indeed show that nontradables tend to be more expensive (relative to
tradables) in richer countries.
One reason for the lower relative price of nontradables in poor countries was suggested
by Bela Balassa and Paul Samuelson.13 The Balassa-Samuelson theory assumes
that the labor forces of poor countries are less productive than those of rich countries in
the tradables sector but that international productivity differences in nontradables are
negligible. If the prices of traded goods are roughly equal in all countries, however,
lower labor productivity in the tradables industries of poor countries implies lower
wages than abroad, lower production costs in nontradables, and therefore a lower price
of nontradables. Rich countries with higher labor productivity in the tradables sector
will tend to have higher nontradables prices and higher price levels. Productivity statistics
give some empirical support to the Balassa-Samuelson differential productivity
postulate. And it is plausible that international productivity differences are
sharper in traded than in nontraded goods. Whether a country is rich or poor, a barber
Figure 16-3
Price Levels and Real Incomes, 2007
Countries’ price levels tend to rise as their real incomes rise. Each dot represents a country.
The straight line indicates a statistician’s best prediction of a country’s price level relative to
that of the United States based on knowing its real per capita income.
Source: Penn World Table, version 6.3.
CHAPTER 16 Price Levels and the Exchange Rate in the Long Run 403
can give only so many haircuts in a week, but there may be a significant scope for
productivity differences across countries in the manufacture of traded goods like
personal computers.
An alternative theory that attempts to explain the lower price levels of poor countries
was put forth by Jagdish Bhagwati of Columbia University, and by Irving Kravis
of the University of Pennsylvania and Robert Lipsey of the City University of New
York.14 The Bhagwati-Kravis-Lipsey view relies on differences in endowments of
capital and labor rather than productivity differences, but it also predicts that the relative
price of nontradables increases as real per capita income increases. Rich countries
have high capital-labor ratios, while poor countries have more labor relative to capital.
Because rich countries have higher capital-labor ratios, the marginal productivity of
labor is greater in rich countries than in poor countries, and the former will therefore
have a higher wage level than the latter.15 Nontradables, which consist largely of
services, are naturally labor-intensive relative to tradables. Because labor is cheaper in
poor countries and is used intensively in producing nontradables, nontradables also
will be cheaper there than in the rich, high-wage countries. Once again, this international
difference in the relative price of nontradables suggests that overall price levels,
when measured in a single currency, should be higher in rich countries than in poor
countries.
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