Prices and Inflation

views updated

Prices and Inflation

When looking at the relationship between inflation and international trade, economists focus on a few important variables. These are domestic and foreign price levels, the exchange rate or the domestic currency price of foreign money (e.g., yen per dollar), and the tradability of a good. These variables and some basic economic relationships establish a number of important principles that help explain some forms of international trade.


A conventional starting point is the law of one price, or LOOP. Assume for a moment that the costs to international trade including transportation costs, insurance, information acquisition about local markets and distribution chains, and exchange rate risk do not exist. Next, look at one commodity or good that is sold in two countries and is of identical quality in either location. When the prices are measured in the same currency, LOOP states that the price in one country equals the price in the other country.

This reasonable law hinges on the fact that there are arbitrageurs who can make vast amounts of money if prices were unequal. Suppose for a moment that the price of wheat in New York was $1 per bushel and in London it was $2 per bushel. To make a profit, one buys wheat in New York, ships it to London, and sells it at the higher price. By doing so, the price will rise in New York and the increased supply of wheat in London will cause the price to fall there. This will happen until the price in both markets is equalized. Throughout the process, we can see that the trade balance for this particular good will improve for the United States and worsen for the United Kingdom.

When in 1980 the economist C. Knick Harley looked at the nineteenth-century London–New York wheat market, he found a massive convergence in New York–Liverpool wheat prices over time, driven largely by technological improvements in shipping. From the 1880s until at least 1913, when the study finished, the law of one price held fairly well. For nearly this entire period theUnited States was a net exporter of wheat to the United Kingdom (itself a net importer) as the forces of arbitrage would demand.


If all goods were tradable and LOOP held for each good, then it must be the case that the aggregate price levels of comparable groups of goods in two countries, when expressed in the same currency, would be equal. This idea is known as purchasing power parity, or PPP. PPP suggests quite intuitively that if prices in Japan increased, and the exchange rate between Japan and the United States is floating, that the dollar should appreciate versus the Japanese yen. When focusing on the changes rather than the actual price ratios, one refers to relative purchasing power parity. Whether it is arbitrage as described above or monetary theories of exchange rate movement that makes the price ratio stay relatively constant over time is a matter of debate. Needless to say, both adjustment mechanisms likely play a role.

The interwar period illustrates how extreme situations can provide some evidence for relative PPP. In France monetary policy was loose and produced higher rates of inflation in the general price level when compared to the U.S. price level. The magnitude of consumer price inflation between 1921 and 1926 was roughly 85 percent. In turn, the French franc depreciated against the U.S. dollar by about 95 percent. Similarly, extreme inflation and depreciation went hand in hand in Germany, Austria, and Poland in the 1920s. These episodes and other extreme events like them illustrate the power of purchasing power parity to explain changes in exchange rates and prices.

Nevertheless, in more normal times and in the short run it may be that PPP does seem to hold. Price-level differentials are rarely erased immediately, although many contemporary studies suggest that the half-life of price differences (i.e., the time it takes for price differentials to go to zero) is never longer than between three and five years.

LOOP often appears to fail even simple tests also. For example, the Economist magazine regularly reports dollar prices of the McDonald's Big Mac for a number of countries. Price disparities abound. At some points in time, dollar prices of Big Macs have been found to vary between countries by nearly 100 percent. Because the Big Mac is a tradable good and has a standard of quality across the planet, the difference could be attributable the fact that arbitrage has not fully played itself out at the time of the survey. Or there may have been changes to the supply and or demand of Big Macs, making the price temporarily diverge from its equilibrium value. Yet another possibility is that local prices do not move in the short term because McDonald's would have to reprint all of its menus and change its signs. These menu costs presumably impede price changes when the gains from arbitrage are lower than the costs from changing the menu.

Another explanation could be that the exchange rates between the United States and a particular country were fixed. When this happens and general inflation overtakes a foreign country, say due to high government spending, we say that a currency is overvalued. Generally a country in this situation would develop a trade deficit as imports would seem relatively cheaper. The trade deficit could be financed by losses of foreign-exchange reserves. In the absence of any other change in policy by the monetary authorities, the loss of reserves could mean a decrease in the domestic money supply, falling prices, and eventually a return to a trade balance due to enhanced price competitiveness of exports versus imports. This is called a real devaluation. This process, outlined by David Hume (1711–1776) in the eighteenth century, was called the price-specie-flow mechanism and was tailored to a world where a gold standard and fixed exchange rates prevailed.

Proponents of PPP tried to influence the reestablishment of the global gold standard in the 1920s. They attempted to calculate the necessary change in pre–World War I exchange rates that would compensate the differential inflation rates between the major countries. For example, in order to regain the prewar exchange rate with the United States of $4.86 per pound, the United Kingdom underwent a deflation from 1920 to 1925 in an attempt to regain the necessary price level. The pound was fixed to gold and the dollar at the prewar parity in 1925 (see Jeanne and Eichengreen for more on this episode).


One final reason that price level differential could exist between countries even if the face of an intentionally integrated market is called the Balassa-Samuelson effect. Bela Balassa and Paul Samuelson are credited with formal analysis of the phenomenon that wealthier countries have higher average price levels. How could this be?

A distinction between tradable and nontradable goods was made in their conjectures. Nontradable goods are those such as haircuts and construction services. Such goods could be shipped across international borders, but the costs of doing so plus the original price are usually larger than the value of a similar good at home, making arbitrage impractical. Once the world's goods are separated this way, the idea is to assume that LOOP holds in the tradable sector, that industries in the tradable sector are more productive than the nontradable sector, that the nontradable industries are roughly equally productive in any country, and that more productive countries (i.e., the wealthier countries) pay higher wages to their workers precisely because of their higher productivity. In this case, the wages of workers in the nontradable sector and also the prices of the nontradable sector in the more productive countries are bid up as the relatively richer workers in those countries can afford to pay more for such services. All of this adds up to a higher price level in the more productive countries than in the poorer countries.

The Balassa-Samuelson effect is evident in the data over the last thirty years. However, new research by Paul Bergin, Reuven Glick, and Alan M. Taylor has shown that there is no evidence that richer countries in 1913 had higher price levels, but that since the 1950s richer countries have had increasingly higher price levels than poorer countries. Although the Balassa-Samuelson effect is one explanation of the data for the 1990s, the authors underscore the fact that many other circumstances can give rise to this fact and might account for the change over time in this relationship. Their preferred explanation suggests that the goods that came to be tradable were those undergoing the fastest productivity advance. Over the long run the world has come to resemble more the assumptions of the basic Balassa-Samuelson model.

SEE ALSO Gold and Silver; Gold Standard;Quantity Theory of Money.


Balassa, Bela. "The Purchasing-Power Parity Doctrine: A Reappraisal." Journal of Political Economy 72 (December 1964): 584–596.

Harley, C. Knick. "Transportation, the World Wheat Trade, and the Kuznets Cycle, 1850–1913." Explorations in Economic History 17, no. 3 (1980): 218–250.

Jeanne, Olivier, and Eichengreen, Barry. "Currency Crisis and Unemployment: Sterling in 1931." In Currency Crises, ed. Paul Krugman. Chicago and London: University of Chicago Press, 2000.

Samuelson, Paul A. "Theoretical Notes on Trade Problems." Review of Economics and Statistics 46 (May 1964): 145–154.

Christopher M. Meissner