Parity Conditions and Currency Forecasting the Law of One Price

Total Page:16

File Type:pdf, Size:1020Kb

Parity Conditions and Currency Forecasting the Law of One Price Chap. 4 (b) Parity Conditions and The Law of One Price Currency Forecasting • This is the assumption that identical goods sell for the same price worldwide. • Forecasts based on the Law of One Price. • Suppose gold trades in NYC at $300/oz. and in London • The Big Mac Index at $310/oz. • Forecasts based on Relative Purchasing Power Parity. • Where will people trade their gold? • Inflation and the Real Rate of Interest • The New York market would mostly attract buyers, • The original Fisher Effect. while the London market would mostly attract sellers. • The International Fisher Effect. • Also, arbitrage would occur: trades could “short-sell” gold in London, and simultaneously buy gold in NYC. • Sept. 19, 2002 by William Pugh • Gold prices in the two markets should soon equalize The Law of One Price and The Law of One Price Purchasing Power Parity • Purchasing power parity is often interpreted as, • What would cause a violation of the law of one starting with a set amount of dollars, converting price? those dollars into another currency buys the • If goods are not easily tradable, they are are same “market basket of goods” in the foreign difficult to arbitrage. country that it would in the U.S.A. • This is the really just the law one price. • Examples of nontradable goods?: • However we will find that this “law” is true only in a very limited sense. Violations of the Law of One Price Violations of the Law of One Price • Haircuts • Law of one price does not hold for nontradable • Taxi rides goods even within the United States! • Restaurant Meals (Big Macs) • Rents in New York City vs Lochapoka, AL • Apartments • Big Macs in Alaska vs. Auburn • Cement Blocks? • Big factors: shipping considerations, • Agricultural Products (most countries have perishability. protectionist policies). 1 Purchasing Power Parity Purchasing Power Parity • (1) Absolute PPP: Prices should be about the • In this text and this course we will assume that same in different countries (at current exchange the strict PPP only holds for tradable goods and rates) not for nontradable goods that, say, a tourist pays for: rents, meals, transportation, personal • or a “market basket” of goods should cost the services, etc. same everywhere in, say, dollar terms. • The strict PPP is sometimes called absolute PPP • (2) Relative PPP:Differences between countries’ price levels should be constant over time • or any differences in the cost of a “market basket”, between countries, should persist over time in, say, dollar terms. Relative Purchasing Power Parity Forecasting with Absolute PPP • The text refers to RPPP as just PPP • The law of one price extended to a market • Based on converting Swiss francs & Pesos to basket of goods (including a Big Mac for lunch after shopping). Absolute PPP says the currency some common currency (e.g. the $): if the cost of with the cheaper goods should appreciate or the living in Switzerland is twice as expensive as the currency with the more expensive goods and Mexico today, then RPPP says Switzerland will services should depreciate. be twice as expensive next year. • The Economist’s Big Mac Index is attempting • Relative PPP does not predict any convergence to forecast future exchange rates based on the in the cost of living between two countries. cost of the Big Mac. • In fact it assumes there will be no convergence! • The magazine appears to assuming that Absolute PPP is valid for nontradable goods. Forecasting with Absolute PPP Forecasting with (Relative) PPP • The Law of One Price, using the the Big Mac • RPPP says the currency with the higher inflation rate Index, predicts that the CHF will fall and the is expected to depreciate relative to the currency with Argentine Peso will rise. the lower rate of inflation. • We will find that Relative PPP predicts the • Domestic inflation: Remember, high inflation means a opposite. currency is losing local purchasing power. • Switzerland, like NYC, has been expensive for a • It is not unreasonable to assume that the same currency long time and will probably remain so. will also lose purchasing power on overseas goods and • The Economist is ignoring Argentina’s inflation services. and political turmoil. • With PPP, this loss of overseas purchasing power is • The Argentine Peso may fall further as the weak through a drop in the currency’s exchange rate. government prints too many pesos. 2 Forecasting with (Relative) PPP Forecasting with (Relative) PPP • Suppose Mexico has 10% inflation next year. It now • Suppose the peso is currently worth $0.10 ( e = $.10) costs ten percent more pesos to buy Mexican cars, food, 0 vacations, etc. • In Mexican terms, the USD ‘costs’ ten pesos. • Also, suppose the U.S. has no inflation, so cars, etc. still • If Mexico’s 10% inflation extends to foreign currency, cost the same in the U.S. (in terms of the USD). then the USD should rise in cost to 11 pesos. • If the exchange remains fixed, American consumers • The new spot rate (in American terms) will fall to will now want to wants U.S. goods and services over Mexican goods and services (which are now more 1USD/Peso11 = $.909 expensive). • e1 = e0 (1 + ih)/(1 + if) = $0.10 (1 + 0)/(1 + .10) = $.909 • Mexicans will want more American products and these • where e = expected future spot rate, e = spot rate, still sell at the old peso price. 1 0 i = expected home (USA) inflation (and is zero), and • Thus more demand for the USD, less demand for the h peso. The price of the peso should fall until?.... if = expected foreign inflation. Values only known in the future (uncertainties) are represented by italics. Forecasting with (Relative) PPP Forecasting with Relative PPP • e1 = e0 (1 + ih)/(1 + if) Note, this very important • The general version for “t” periods is equation uses direct quotes. e = e (1 + i )t/(1 + i )t or • If the U.S. also has inflation - assume two percent - • t 0 h f then we would expect the peso depreciation to be less • In the previous example, if the Peso is worth ten severe. cents today, we would estimate that the peso • e1 = e0 (1 + ih)/(1 + if) would be worth • = $0.10 (1 + .02)/(1 + .10) • $0.10(1.02)/(1.10) = $0.0927 in one year • = $.927 $0.10(1.02)2/(1.10)2 = $0.0856 in two years • Exhibit 4.5 shows a relationship between changes in $0.10(1.02)3/(1.10)3 = $0.0797 in three years exchange rates and relative inflation rates. Yen: lowest inflation, held value best. PPP: Real Exchange Rates PPP: Real Exchange Rates • Suppose Mexico has 10% inflation, we have none. From • PPP is based on the assumption that real the previous example, we found that we could expect the ’) exchange rates ( et stay the same. Peso to fall from $0.10 to $0.0909. ’ • That is, the barter exchange rate of goods stays • e1 = e1(1 + if)/(1 + 0) the same between countries, so exchange rates • = .09107 (1 + .10) = .10 adjust to differences in inflation. • (1) If the peso falls to $.0909, we say the peso’s real exchange rate is unchanged. ’ t t • et = et(1 + ih) /(1 + if) is constant. • (2) If the peso falls more than 0.0909, it has fallen in • This property is usually violated in the short run real terms. but appears to hold up in the long run. • (3) If it stays at 10 cents we say it has risen in real terms. 3 PPP: Real Exchange Rates Inflation and “Real” Interest Rates • It is important that you understand, at least intuitively, the logic of the these three outcomes. • We often make a distinction between the normal everyday contract rate of interest, and the • Again, real exchange rates are rarely constant in the short run but appears to be steady in the long run. interest rate that is adjusted for any loss of purchasing power caused by inflation. • Look at the 9 graphs in Exhibit 4.6: the dark steady lines represent a constant real (inflation-adjusted) exchange • The everyday contract rate is called the nominal rate. interest rate, denoted in the text as “r”. • The blue, wiggly lines are the actual rates. • The rate adjusted to any reflect loss of • The real rate acts like a ‘magnet’ for the actual exchange purchasing power is the real rate, denoted in rate. textbook as “a”. • Irving Fisher popularized the use of the real rate and thus the relationship was named after him. Inflation and “Real” Rates Inflation and “Real” Rates • A simple version of this “Fisher Effect” is a • The T-bill rate is more like 1.7%, so the real T- = r- i, where a is the expected real rate, r is the bill rate is expected to be 0.2%. nominal rate, and i is expected inflation. • Note that each nominal rate has its own • Under current conditions this would be: the T- corresponding real rate. bond YTM is 3.9%, inflation is expected to be 1.5%, therefore the expected real rate on the • There is, however, an interaction effect that is T-bond is 2.4% . reflected in the full, more correct formula: • Note: the real rate is usually the residual of the • (1+a) = (1 + r)/(1 + i) nominal rate and inflation. That is, you start • or (1+r) = (1 + a)(1 + i) = 1 + a + i + a*i with some nominal rate and inflation and compute the real rate. • r = a + r + a*r where a*i is similar to compounding between i and a. Inflation and “Real” Rates Inflation and “Real” Rates • Example: Suppose we expect Russia to have • Not just 105% 100% inflation next year and we want an • (1+r) = (1 + a)(1 + i) investment that will increase our purchasing • r = (1 + a)(1 + i) -1 power by 5% (the real return).
Recommended publications
  • The Law of One Price Lagen Om Ett Pris
    LIU-IEI-FIL-A—09/00489—SE Linköping University, Sweden Department of Management and Engineering Master’s Thesis in Finance 15hp The International Business Program Spring 2009 The Law of One Price Evidence from Three European Stock Exchanges Lagen om ett pris Bevis från tre europeiska börsmarknader Author: – Sanna Olkkonen – Supervisor: Göran Hägg The Law of One Price – Evidence from Three European Stock Exchanges Abstract For the last decades the Efficient Market Hypothesis (EMH) has had a vital role in the financial theory. According to the theory assets, independent of geographic location, always are correctly priced due to the notion of information efficiency across financial markets. A consequence of EMH is the Law of One Price, hereafter simply the Law, which is the main concept of this thesis. The Law extends the analysis by stating that in a perfectly integrated and competitive market cross- traded assets should trade for the same common-currency price in every country. This becomes a fact due to the presence of arbitrageurs’ continuous vigilance in the financial markets, where any case of mispricing is acted upon in a matter of seconds by buying the cheaper asset and selling it where the price is higher in order to make a profit from the price gap. Past research reveals that mispricing on cross-traded assets does exist, indicating that there exists evidence of violations of the Law on financial markets. However, in the real world most likely only a few cases of mispricing equal arbitrage opportunities due to the fact that worldwide financial markets are not characterized by the perfect conditions required by Law.
    [Show full text]
  • Market Integration and Convergence to the Law of One Price
    Market Integration and Convergence to the Law of One Price: Evidence from the European Car Market∗ Pinelopi Koujianou Goldberg Frank Verboven Yale University and NBER Catholic University of Leuven and CEPR December 2003 Abstract This paper exploits the unique case of European market integration to investigate the relationship between integration and price convergence in international markets. Using a panel data set of car prices we examine how the process of integration has affected cross- country price dispersion in Europe. We find surprisingly strong evidence of convergence towards both the absolute and the relative versions of the Law of One Price. Our analysis illuminates the main sources of segmentation in international markets and suggests the type of institutional changes that can successfully reduce it. JEL Codes: F0, F15, L62 Keywords: International Price Dispersion, Law of One Price, Market Integration, Price Convergence, European Automobile Market ∗Corresponding author: Pinelopi K. Goldberg; Address: Department of Economics, Yale University, 37 Hillhouse Avenue, P.O. Box 208264, New Haven, CT 06520-8264; Telephone: (203) 432-3569; Fax: (203) 432-6323; Email: penny.goldberg@yale.edu. Address of Frank Verboven: Faculty of Economics and Applied Economics, Katholieke Universiteit Leuven, Naamstestraat 69, B-3000 Leuven, Belgium; Email: frank.verboven@econ.kuleuven.ac.be. 1 1Introduction1 This paper uses the European integration process as a case study to explore the link between integration and price convergence in international markets. Few topics have attracted as much attention and controversy in International Economics as the topic of convergence to the Law of One Price (LOOP). While until a few years ago, one was hard-pressed to find evidence in favor of the convergence hypothesis, a number of recent papers claim that Purchasing Power Parity does hold in the long run, with a half-life of shocks of five to six years (see Obstfeld and Rogoff (2000) for a detailed discussion).
    [Show full text]
  • Lecture 02: One Period Model
    Fin 501: Asset Pricing Lecture 02: One Period Model Prof. Markus K. Brunnermeier 10:37 Lecture 02 One Period Model Slide 2-1 Fin 501: Asset Pricing Overview 1. Securities Structure • Arrow-Debreu securities structure • Redundant securities • Market completeness • Completing markets with options 2. Pricing (no arbitrage, state prices, SDF, EMM …) 10:37 Lecture 02 One Period Model Slide 2-2 Fin 501: Asset Pricing The Economy s=1 • State space (Evolution of states) s=2 Two dates: t=0,1 0 S states of the world at time t=1 … • Preferences s=S U(c0, c1, …,cS) (slope of indifference curve) • Security structure Arrow-Debreu economy General security structure 10:37 Lecture 02 One Period Model Slide 2-3 Fin 501: Asset Pricing Security Structure • Security j is represented by a payoff vector • Security structure is represented by payoff matrix • NB. Most other books use the transpose of X as payoff matrix. 10:37 Lecture 02 One Period Model Slide 2-4 Fin 501: Asset Pricing Arrow-Debreu Security Structure in R2 One A-D asset e1 = (1,0) c2 This payoff cannot be replicated! Payoff Space <X> c1 Markets are incomplete ) 10:37 Lecture 02 One Period Model Slide 2-5 Fin 501: Asset Pricing Arrow-Debreu Security Structure in R2 Add second A-D asset e2 = (0,1) to e1 = (1,0) c2 c1 10:37 Lecture 02 One Period Model Slide 2-6 Fin 501: Asset Pricing Arrow-Debreu Security Structure in R2 Add second A-D asset e2 = (0,1) to e1 = (1,0) c2 Payoff space <X> c1 Any payoff can be replicated with two A-D securities 10:37 Lecture 02 One Period Model Slide 2-7 Fin 501: Asset
    [Show full text]
  • The Law of One Price Without the Border: the Role of Distance Versus Sticky Prices
    NBER WORKING PAPER SERIES THE LAW OF ONE PRICE WITHOUT THE BORDER: THE ROLE OF DISTANCE VERSUS STICKY PRICES Mario J. Crucini Mototsugu Shintani Takayuki Tsuruga Working Paper 14835 http://www.nber.org/papers/w14835 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 April 2009 We are indebted to Chikako Baba, Paul Evans and Masao Ogaki for valuable comments on the earlier draft. We also thank seminar participants at Hitotsubashi, Osaka, Queen's, and Tohoku University and Bank of Canada and Bank of Japan for helpful comments and discussions. Mario J. Crucini and Mototsugu Shintani gratefully acknowledge the financial support of National Science Foundation (SES-0136979, SES-0524868). Takayuki Tsuruga gratefully acknowledges the financial support of Grant-in-aid for Scientific Research. The views expressed herein are those of the author(s) and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer- reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2009 by Mario J. Crucini, Mototsugu Shintani, and Takayuki Tsuruga. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. The Law of One Price Without the Border: The Role of Distance Versus Sticky Prices Mario J. Crucini, Mototsugu Shintani, and Takayuki Tsuruga NBER Working Paper No. 14835 April 2009 JEL No. D4,F40,F41 ABSTRACT We examine the role of nominal price rigidities in explaining the deviations from the Law of One Price (LOP) across cities in Japan.
    [Show full text]
  • Information Frictions and the Law of One Price: “When the States and the Kingdom Became United”
    WTO Working Paper ERSD-2014-12 Date: 16 September 2014 World Trade Organization Economic Research and Statistics Division Information Frictions and the Law of One Price: “When the States and the Kingdom became United” Claudia Steinwender London School of Economics and Political Science Manuscript date: 31 May 2014 Disclaimer: This is a working paper, and hence it represents research in progress. The opinions expressed in this paper are those of its author. They are not intended to represent the positions or opinions of the WTO or its members and are without prejudice to members' rights and obligations under the WTO. Any errors are attributable to the author. Information Frictions and the Law of One Price: “When the States and the Kingdom became United”¦ Claudia Steinwender: London School of Economics and Political Science May 31, 2014 Abstract How do information frictions distort international trade? This paper exploits a unique historical experiment to estimate the magnitude of these distortions: the establishment of the transatlantic telegraph connection in 1866. I use a newly collected data set based on historical newspaper records that provides daily data on information flows across the Atlantic together with detailed, daily information on prices and trade flows of cotton. Information frictions result in large and volatile deviations from the Law of One Price. What is more, the elimination of information frictions has real effects: Exports respond to information about foreign demand shocks. Average trade flows increase after the telegraph and become more volatile, providing a more efficient response to demand shocks. I build a model of international trade that can explain the empirical evidence.
    [Show full text]
  • The Purchasing Power Parity Debate
    Journal of Economic Perspectives—Volume 18, Number 4—Fall 2004—Pages 135–158 The Purchasing Power Parity Debate Alan M. Taylor and Mark P. Taylor Our willingness to pay a certain price for foreign money must ultimately and essentially be due to the fact that this money possesses a purchasing power as against commodities and services in that country. On the other hand, when we offer so and so much of our own money, we are actually offering a purchasing power as against commodities and services in our own country. Our valuation of a foreign currency in terms of our own, therefore, mainly depends on the relative purchasing power of the two currencies in their respective countries. Gustav Cassel, economist (1922, pp. 138–39) The fundamental things apply As time goes by. Herman Hupfeld, songwriter (1931; from the film Casablanca, 1942) urchasing power parity (PPP) is a disarmingly simple theory that holds that the nominal exchange rate between two currencies should be equal to the P ratio of aggregate price levels between the two countries, so that a unit of currency of one country will have the same purchasing power in a foreign country. The PPP theory has a long history in economics, dating back several centuries, but the specific terminology of purchasing power parity was introduced in the years after World War I during the international policy debate concerning the appro- priate level for nominal exchange rates among the major industrialized countries after the large-scale inflations during and after the war (Cassel, 1918). Since then, the idea of PPP has become embedded in how many international economists think about the world.
    [Show full text]
  • Essays on the Law of One Price in Financial Markets and the Recent Financial Crisis
    City University of New York (CUNY) CUNY Academic Works All Dissertations, Theses, and Capstone Projects Dissertations, Theses, and Capstone Projects 2-2017 Essays on the Law of One Price in Financial Markets and the Recent Financial Crisis Igor Sorkin The Graduate Center, City University of New York How does access to this work benefit ou?y Let us know! More information about this work at: https://academicworks.cuny.edu/gc_etds/1830 Discover additional works at: https://academicworks.cuny.edu This work is made publicly available by the City University of New York (CUNY). Contact: AcademicWorks@cuny.edu Essays on the Law of One Price in Financial Markets and the Recent Financial Crisis by IGOR SORKIN A dissertation submitted to the Graduate Faculty in Economics in partial fulfillment of the requirements for the degree of Doctor of Philosophy, The City University of New York 2017 i © 2017 IGOR SORKIN All Rights Reserved ii This manuscript has been read and accepted for the Graduate Faculty in Economics in satisfaction of the dissertation requirement for the degree of Doctor of Philosophy. Date Dr. Merih Uctum Chair of Examining Committee Date Dr. Wim Vijverberg Executive Officer Supervisory Committee: Merih Uctum Wim Vijverberg Thom Thurston Yochanan Shachmurove THE CITY UNIVERSITY OF NEW YORK iii Abstract Essays on the Law of One Price in Financial Markets and the Recent Financial Crisis by IGOR SORKIN Advisor: Professor Merih Uctum Essay 1: The theory of the Law of One Price (LOOP) is one of the most important theories in International Economics. I use financial markets to revisit the validity of the LOOP in the short run, and then extend the analysis into the long-run to examine whether events such as the Financial Crisis of 2007-2009 can lead to the failure of the LOOP or worsen deviations from it.
    [Show full text]
  • Purpose of the Eurostat-OECD PPP Programme
    From: Eurostat-OECD Methodological Manual on Purchasing Power Parities Access the complete publication at: http://dx.doi.org/10.1787/9789264189232-en Purpose of the Eurostat-OECD PPP Programme Please cite this chapter as: OECD/Eurostat (2012), “Purpose of the Eurostat-OECD PPP Programme”, in Eurostat-OECD Methodological Manual on Purchasing Power Parities, OECD Publishing. http://dx.doi.org/10.1787/9789264189232-4-en This work is published on the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the Organisation or of the governments of its member countries. This document and any map included herein are without prejudice to the status of or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city or area. Calculation and aggregation of PPPs 12 Chapter 1: Purpose of the Eurostat-OECD PPP Programme Purpose of the Eurostat-OECD PPP Programme Eurostat-OECD Methodological Manual on Purchasing Power Parities 23 Purpose of the Eurostat-OECD PPP programme1 1.1 Introduction 1.1 The Eurostat-OECD PPP Programme was established in the early 1980s to compare on a regular and timely basis the GDPs of the Member States of the European Union and the Member Countries of the OECD. This remains the purpose of the Programme, although its coverage has been broadened to include countries that are not members of either the European Union or the OECD. These are either countries that have applied to join the European Union or the OECD or countries with which Eurostat and the OECD have programmes of technical cooperation in statistics.
    [Show full text]
  • Empirically Testing the Law of One Price in an International Commodity Market: a Rational Expectations Application to the Natural Rubber Market
    Agricultural Economics, 4 ( 1990) 165-177 165 Elsevier Science Publishers B.V., Amsterdam- Printed in The Netherlands Empirically Testing the Law of One Price in an International Commodity Market: A Rational Expectations Application to the Natural Rubber Market Barry K. Goodwin Department of Agricultural Economics, Kansas State University, Manhattan, KS 66506 (U.S.A.) (Accepted 7 September 1989) Abstract Goodwin, B.K., 1990. Empirically testing the Law of One Price in an international commodity market: a rational expectations application to the natural rubber market. Agric. Econ., 4: 165- 177. The Law of One Price (LOP) is an important ingredient in theories of international trade and exchange rate determination. An important shortcoming of the existing empirical literature is that parity is typically assumed to hold contemporaneously. This overlooks the fact that inter­ national commodity arbitrage takes place over tim~> <<8 well as across spatially separated markets. Recognizing this fact, we expect to see parity holding for expected prices. A model which incor­ porates the expectations of commodity arbitragers is constructed and used to test the LOP in the natural rubber market. Results indicate that the inclusion of expectations may be of value when considering the LOP. Introduction The Law of One Price (LOP) is an important component in theories of international trade and exchange rate determination. The LOP asserts that foreign commodity prices, once adjusted for exchange rates and transportation costs, will be equal to domestic commodity prices. This equality is established and maintained by the profit seeking actions of international commodity ar­ bitragers. Adherence to the LOP implies efficiency in international commodity markets.
    [Show full text]
  • Currency Valuation and Purchasing Power Parity Currency Valuation and Purchasing Power Parity
    Currency Valuation and Purchasing Power Parity Currency Valuation and Purchasing Power Parity Jamal Ibrahim Haidar Introduction The analytical framework of currency valuation is an intellectual challenge and of influence to economic policy, the smooth functioning of financial markets and the financial management of many international companies. The Economist magazine argues that its Big Mac Index (BMI), based on the price of a Big Mac hamburger across the world, can provide ‘true value’ of currencies. This paper provides ten reasons for why the BMI cannot provide a ‘true’ value of currency, and it proposes adjustments to specific misalignments. The purchasing power parity (PPP) theory postulates that national price levels should be equal when expressed in a common currency. Since the real exchange rate is the nominal exchange rate adjusted for relative national price levels, variations in the real exchange rate represent devia- tions from PPP. It has become something of a stylised fact that the PPP does not hold continuously. British prices increased relative to those in the US over the past 30 years, while those of Japan decreased. According to PPP theory, the British pound should have depreciated (an increase in the pound cost of the dollar) and the Japanese yen should have appreci- ated. This is what in fact happened. despite deviations in the exchange rate from price ratios, there is a distinct tendency for these ratios to act as Jamal Ibrahim Haidar is a consultant in the International Finance corporation of the World Bank. WORLD ECONOMICS • Vol. 12 • no. 3 • July–September 2011 1 Jamal Ibrahim Haidar Despite deviations in anchors for exchange rates.
    [Show full text]
  • The Law of One Price in Unfamiliar Places: the Case of International Real Estate∗
    The Law of One Price in Unfamiliar Places: The Case of International Real Estate∗ Thomas Rufy Maurice Levi University of British Columbia University of British Columbia October 27, 2011 Abstract International commodity market arbitrage and its corollary, the law of one price, are generally based on moving the commodity between markets to exploit price differences, making allowance for prevailing exchange rates. This form of arbitrage is clearly impossible for services and immobile objects such as real estate. However, there is the possibility of another form of arbitrage when the buyer can move to the object instead of the object moving to the buyer. Such a situation is possible for the market for international real estate such as recreational properties in exclusive mountain ski resorts and oceanfront estates. By constructing repeat sales indices for several such markets, we find that the price dynamics of international properties differs from local properties in terms of the impact of exchange rates. We show there is a significant long-term equilibrium relationship between the levels of relative prices and exchange rates. Rising values of a country's currency dampen local currency prices of internationally-traded properties relative to domestic properties, and vice versa. Lastly, we provide direct evidence in support of the law of one price for the case of international real estate. (R32, F31) Keywords: exchange rates; international real estate; law of one price; one-way arbitrage ∗Sauder School of Business, University of British Columbia, 2053 Main Mall, Vancouver BC, Canada V6T 1Z2 (Ruf: Thomas.Ruf@sauder.ubc.ca; Levi: Maurice.Levi@sauder.ubc.ca).
    [Show full text]
  • Classical and Neoclassical Roots of the Theory of Optimum Tariffs
    CLASSICAL AND NEOCLASSICALROOTS OF THE THEORY OF OPTIMUM TARIFFS Thomas M. Hump/my In current debates with protectionists, pure or Kaldor demonstrated these propositions with a unilateral free traders insist that unrestricted com- geometrical diagram showing the tariff-imposing merce is optimally advantageous not only for the country choosing to exchange the combination of ex- world as a whole but for any individual nation, even ports for imports that allows it to reach its highest if it practices it alone. From this idea stems the cor- attainable trade indifference curve given the offer ollary that a country automatically benefits from the curve of the foreign country (see Figure 1).2 unilateral as well as reciprocal elimination of tariffs. Shortly after, in 1944, Abba Lerner in his Economics If true, it follows that, far from erecting tariffs, a coun- of COHTVIdescribed how the same propositions could try should immediately dismantle them and enjoy the be illustrated with conventional demand and supply benefits of international specialization and division curves (see Figure 2). 3 Both diagrams quickly of labor even if other nations do not. worked their way into international trade textbooks In 1940, however, the British economist Nicholas Kaldor challenged these notions by asserting that a 2 Kaldor, p. 379. tariff always benefits the levying country provided 3 A.P. Lerner, Th Economics of Contmi(New York, Macmillan, that the duty is not too large, that the country has 1944), pp. 357-59. monopoly power in world markets, and that other countries do not retaliate with tariffs of their own.’ Kaldor was here advancing the terms-of-trade or optimum tariff argument according to which trade taxes improve the levying country’s welfare by turning the commodity terms of trade (relative price at which exports exchange for imports or the quan- tity of imports bought by a unit of exports) in its favor, thus giving it a better bargain in world markets.
    [Show full text]