In 2012, the gross national income (GNI) per capita in the U.S. was $50,120. Converting incomes using the exchange rate, the GNI per capita in China was $5,740. Comparing dollar incomes using the dollar prices of baskets of consumer goods, Chinese GNI per capita was $9,210 in terms of U.S. consumer goods. This implies that PPP does not hold: Deviations from Purchasing Power Parity

Limits to arbitrage A more realistic portrayal of international trade is to introduce trade costs. Suppose a good sells for P = $100 in Home, and it costs $10 to ship the good from Home to Foreign. The trade cost is c = 0.1 = 10%. The cost of the good on arrival in Foreign, including the trade cost, would be P × (1 + c) = $110. The ratio of the prices is q = EP * /P, where q is the real exchange rate of the home country. Thus, if P = $100 and EP * = $110, then q = 1.1.

Arbitrage from Home to Foreign is profitable only if q = EP*/P > 1 + c, and from Foreign to Home only if 1/q = P/(EP*) > 1 + c. So, taking trade costs into account, the no arbitrage condition for market equilibrium is: Limits to arbitrage

Trade costs Empirical research suggests that trade costs are affected by economic policies, as well as by characteristics of goods and their markets. Average tariffs of 5% (rich countries) or more than 10% (developing countries) constitute an additional cost, and such tariffs vary widely by type of good. Quotas and regulatory barriers also add to trade costs, but the costs they add are difficult to compute. Other causes of price gaps include distance between markets, international borders, having different currencies, having floating exchange rates, and so on.

Total global trade costs are large! Transport costs21% Freight11% Transit (time costs) 9% Border costs44% Tariffs & nontariff barriers 8% Language barrier 7% Currency transactions 14% Security and similar 9% Total international trade costs74%

Burgers and wages

Nontraded Goods and the Balassa-Samuelson Model Using two goods—one traded and one not traded—we can explain price level differences and deviations from PPP. 1. The traded good has the same price in both countries. 2. Productivity (A) in traded goods determines wages. Wage levels in each country are equal to productivity levels. 3. Wages determine the prices of nontraded goods.

Nontraded Goods and the Balassa-Samuelson Model What do these three assumptions imply? Countries with higher traded goods productivity will have relatively high wages and hence relatively high prices of nontraded goods. This means they will also have relatively higher overall price levels, depending on how large the share of nontraded goods in the consumption basket is.

Suppose the nontraded goods share of consumption is n (so the traded share is 1 − n). Changes in Productivity If Home productivity A increases, by ΔA/A; the price of traded goods is unchanged, at 1, and the price of nontraded goods A rises, then the (percentage) change in the Home price level is: Nontraded Goods and the Balassa-Samuelson Model

Changes in Productivity A change in the Foreign dollar price level will result from a change in foreign productivity:

Subtracting the first equation above from the second, the change in the real exchange rate is Relative productivities in the traded goods sector drive relative prices through their effects on wages and prices in the nontraded sector.

The relationship between productivity and the real exchange rate is called the Balassa-Samuelson effect (named for the economists Bela Balassa and Paul Samuelson): When compared with other countries, a country experiencing an increase in productivity will see wages and incomes rise and will see its real exchange rate appreciate, meaning that its price level will rise. Nontraded Goods and the Balassa-Samuelson Model

Real Effective Exchange Rates for U.S. and Japan,

Eurozone real exchange rate movements

The definition of the real exchange rate, led to the relationship between the rate of nominal depreciation and real depreciation: To forecast the nominal exchange rate, we need to forecast inflation and forecast changes in the real exchange rate. Deviations from Purchasing Power Parity

Exchange rate adjustment If we forecast a 1% real appreciation. The equation shows that this could imply either a 1% nominal appreciation or an extra 1% of home inflation over and above foreign inflation (or some combination of these). A real undervaluation of Home currency means that either Home goods prices must rise or the Home currency must appreciate. Either makes Home goods more expensive. A real overvaluation means that either Home goods prices must fall or the Home currency must depreciate. Either makes Home goods less expensive.

Is the Chinese yuan undervalued? The Balassa-Samuelson model predicts: In 2000, the real exchange rate with China was q = 0.231, below the predicted equilibrium level of q = The yuan was undervalued and would have to experience a 38% real appreciation (0.088/0.231) against the U.S. dollar. PPP convergence would cut this gap so that 19% would be eliminated in five years: an approximate 3.5% annual increase in q due to convergence. The 6% differences in annual growth rates (China minus United States) imply a further 0.4 × 6 = 2.4% annual real appreciation of the yuan.

Adding up both effects, the model predicts a real yuan appreciation of = 5.9% per year. Either the yuan must appreciate against the dollar (in nominal terms), or inflation in China must rise. (Inflation in China was not much higher than in the U.S.) In 2005, China switched from pegging to the dollar to an unofficial crawling peg. This allowed the yuan to appreciate gradually against the dollar. The Chinese government may have bowed to U.S. protectionist pressure, but it also wanted to keep domestic inflation at reasonable level.