The Purchasing Power International Finance Puzzle

The purchasing power puzzle is an example of the exchange rate disconnect puzzle. According to the purchasing power parity (PPP), changes in exchange rates should reflect inflation differentials between countries. However, empirical studies show that short-term deviations from the PPP are quite persistent.

The real exchange rate includes the ratio of two countries’ price levels and the nominal exchange rate. It implies:

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Here, RER, PE, and PUS indicate the real exchange rate, the price of the Euro-zone’s consumption basket, and the price of the U.S. consumption basket, respectively. In this equation, if you multiply the dollar–euro exchange rate by the price of the European consumption basket (denominated in euro), euros cancel, and you have the price of the European consumption basket in dollars.

Therefore, the real exchange rate compares the price of a country’s consumption basket to that of another country in a common currency.

You can relate the real exchange rate to the purchasing power puzzle in the following way. The previous equation of the real exchange rate includes the nominal exchange rate, and you know that the short-run changes in the nominal exchange rate don’t reflect the changes in macroeconomic fundamentals (in this case, the price levels of two countries).

Because the volatility in the nominal exchange rate is much more than the volatility in domestic and foreign price levels, then the volatility in the real exchange rate is high as well.

The question is, what can generate large and persistent international price differentials? Here are some possible answers:

  • The exchange rate pass-through implies the effect of changes in the exchange rate on import prices in home currency. You may expect that, eventually, the changes in consumer prices will reflect the changes in import prices. But even though the exchange rate pass-through takes place, consumer prices adjust sluggishly to changes in import prices.

  • Another popular explanation of persistent international price differentials is based on imperfect competition. As opposed to perfect competition where firms are price takers (they take the market price of their products), in imperfect competition producers have the opportunity to price their products as well as price discriminate in home and foreign markets.

    Then the argument goes that if most traded goods are produced under imperfect competition, price differentials become persistent. But although the production of some traded goods under the conditions of imperfect competition is reasonable (such as cars), it doesn’t apply to other traded goods (such as apparel).

  • A variation of the previous argument is used for wholesalers, which doesn’t require the firms to be monopolies. Clearly, consumers can’t profitably arbitrage price differences in traded goods, but wholesalers should be able to. Apparently, something is preventing wholesalers from engaging in international price arbitrage at the wholesale level.

    Perhaps wholesalers don’t have control over firms’ legal rights, such as marketing licenses that enable firms to price discriminate, in other words, to charge different prices in different countries.

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