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• W338424387 abstract "An important determinant of a country's external payments position is its international competitiveness. The most common approach to the analysis of competitiveness involves a comparison of movements in exchange rates and prices, based on the concept of purchasing power parity (PPP). This approach predicts that real exchange rates should tend to return to a constant long-run equilibrium in response to short-run shocks and, therefore, that nominal exchange rate movements should tend to offset relative price movements. Empirical evidence suggests that PPP-based indicators may be useful to explain long-run movements in exchange rates among industrial countries, but less so to explain movements of these exchange rates in the short run, or of exchange rates between industrial and developing countries, either in the long or the short run. Examining changes in competitiveness alone is also not very helpful in explaining developments in external trade. It is necessary to incorporate the analysis of competitiveness in a broader framework--taking into account structural and cyclical economic developments, government policies, and financial market conditions--that may explain long-lasting changes in equilibrium real exchange rates. What is Purchasing Power Parity? Three versions of PPP have traditionally been used in the literature: the law of one price, which relates exchange rates to prices of individual homogeneous goods in different countries; absolute PPP which relates exchange fates to overall price levels; and relative PPP which relate exchange rate changes to inflation rates. The law of one price states that when there are no transaction costs or trade barriers (such as tariffs or quotas), the prices of identical goods sold in different countries should be the same when expressed in a common currency. Empirically, the law of one price appears to hold well for homogeneous primary commodities traded on major exchanges, when adjustments are made for contract differences and delivery lags. Not surprisingly, however, the prices of differentiated products, such as manufactured goods and services, tend to deviate to a greater degree from the law of one price. Absolute PPP extends the law of one price to the general price level. Absolute PPP predicts that the same basket of goods and services should cost the same amount in all countries when expressed in a common currency. Clearly, if the law of one price holds for every good, then absolute PPP should also hold. Absolute PPP, however, requires the parity relationship to hold only on average for all goods--not strictly for each good. Absolute PPP provides a specific equilibrium concept for the nominal exchange rate, namely, the PPP exchange rate. This is defined as the rate that equalizes the prices of a common basket of goods in two different countries. Deviations between the market exchange rate and the PPP exchange rate are viewed as short-lived, as they should be eliminated by arbitragers purchasing goods in one country and selling them in another. Despite their intuitive appeal, the empirical usefulness of the law of one price and of absolute PPP is limited. Transportation and information costs and institutional impediments to trade, such s tariffs and quotas, may limit consumers' and firms' responses to cross-country price differences, thus preventing absolute price levels from being equalized internationally. Relative PPP is a yet weaker condition than absolute PPP and predicts only that changes in nominal exchange rates should equal the difference between domestic and foreign inflation on equivalent baskets of goods. If PPP is judged to hold in some particular year, one can obtain, from a time series of the inflation differential, the implied PPP nominal exchange rate, which can then be compared with the market exchange rate. Deviations from Parity Most economic theories suggest that PPP should hold in the long run for traded goods, assuming that measurement problems involved in constructing comparable price deflators can be resolved. …" @default.
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• W338424387 date "1995-01-01" @default.
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• W338424387 title "National Competitiveness and Purchasing Power Parity" @default.
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