The Anatomy of Real Exchange Rates

Vanderbilt University, Nashville TN

Investigators

Abstract

A time immemorial question in international economics asks what determines the relative price of a good, or a basket of goods, in one country vis-a-vis another. The first generation of empirical work, utilizing primarily consumer price indices, has documented large and persistent deviations from 'purchasing power parity' (PPP). The outcome has been more one of raising additional questions than providing answers. The research agenda proposed here follows a second generation of work taking the next logical step: examining panel data on local currency prices of literally thousands of individual goods and services across many different countries. This project blends theoretical and empirical analysis to better understand how relative prices of individual goods evolve over time, how this relates to the behavior of aggregate relative prices, and what this tells us about nominal exchange rates. This project consists of three related parts. The essence of each is new data on many goods and services across many countries and time periods. An important goal of the project is to make these data available publicly. The first part focuses on the European Union, studying good-by-good deviations from the Law-of-One-Price for over 5,000 goods and services for the years 1975, 1980, 1985 and 1990. It finds that between most countries there are roughly as many overpriced goods as there are underpriced goods. This phenomenon is stable across time, in spite of relatively large swings in nominal exchange rates. Equally weighted averages of Law-of-One-Price deviations are small, especially after controlling for national income levels. CPI-weighted averages are also small, indicating that deviations from Purchasing Power Parity (PPP) are small. Cross-sectional dispersion, in contrast, is large, but it is related to economically meaningful characteristics of goods such as international tradability, tradability of factors of production and the competitive structure of the markets in which the goods are sold. The second part extends the work to 122 cities across 79 countries. Compared to Europe, we find both similarities and differences. We find, as others have, that price levels are lower in relatively poor countries. When we distinguish between traded and non-traded goods we find that the latter play a dominant role in explaining the behavior of aggregate international relative prices. A decrease in the overall level of price dispersion between 1990 and 2000, for instance, is primarily attributable to convergence in the prices of non-traded goods. The third project models the dynamics of microeconomic prices. Preliminary results find that the half-lives of deviations from the Law-of-One-Price are less than 1 year for most goods. This differs from previous work based on aggregate price indices, which has produced estimates between 3 and 5 years. Further dynamic reconciliation of our data, both across time and data sets, remains work-in-progress. Once complete, this reconciliation will open up many new lines of inquiry.