Purchasing Power Parity and New Trade Theory

IMF Working Papers, February 1, 2002

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Purchasing Power Parity and New Trade Theory

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Bibliographic details

• Authors: Luca A Ricci, Ronald MacDonald
• Published: February 1, 2002
• Series: IMF Working Papers
• DOI: https://doi.org/10.5089/9781451845129.001

Summary

• The paper theoretically derives and empirically tests implications of a new trade theory framework for systematic movements in the real exchange rate.
• Focus areas:
  • Effect of imperfect substitutability of tradables.
  • Importance of competitiveness, for which the authors construct an original proxy.
• Empirical approach: panel dynamic OLS estimation of nine bilateral US dollar real exchange rates to derive long-run coefficients for relative productivity and competitiveness in the tradable and non-tradable sectors, controlling for standard macroeconomic variables.
• Key conclusion: The implications of imperfect substitutability of tradables fit the data better than the standard neoclassical assumption of price equalization. The new measure of competitiveness is statistically significant in explaining deviations from PPP.

Major findings and empirical results

• Imperfect substitutability of tradables provides a better fit to observed real exchange rate movements than price equalization under standard neoclassical assumptions.
• The constructed competitiveness proxy is statistically significant in explaining deviations from Purchasing Power Parity (PPP).
• Long-run coefficients are derived for:
  • Relative productivity (tradable and non-tradable sectors).
  • Competitiveness (tradable and non-tradable sectors).

Methodology

• Estimation technique: panel dynamic OLS.
• Data: nine bilateral US dollar real exchange rates.
• Controls: standard macroeconomic variables (not enumerated on the page).

Policy and analytical implications

• Accounting for imperfect substitutability of tradables is important for modeling real exchange rate dynamics and deviations from PPP.
• Competitiveness—measured via the authors' original proxy—matters for explaining real exchange rate deviations and should be incorporated into analyses of exchange rate behavior and related policy considerations.

Content in this bundle

• Purchasing Power Parity and New Trade Theory - WP/02/32
  • Purchasing Power Parity and New Trade Theory - WP/02/32 (Markdown version)
  • Purchasing Power Parity and New Trade Theory - WP/02/32 (PDF)