International Financial Systems: On overview of basic facts

Lecture notes 1, PartIIB

Giancarlo Corsetti
Cambridge November 2012
Contents
1 Foreign wealth: net vs gross positions 3
2 Exorbitant privilege, monetary sovereignty, original sin 23
3 International reserves 30
4 The international monetary system 39
5 Conclusions 52
1 Foreign wealth: net vs gross positions
From the basic accounting identity relating Gross Domestic Product (GDP),
denoted Y, to components of aggregate demand: Consumption C, Invest-
ment I, Government Spending on nal goods and services G and net exports
NX, we havve
GDP = Y =
demand by domestic residents or absorption

C +I +G +NX

net demand for domestic goods
it follows that the trade balance of a country, recording exports and imports
of goods and services, is the dierence between GDP and absorption
NX = Y (C +I +G)
Countries own portfolios of external assets and borrow from abroad. Let B
denote the stock of net foreign assets at the beginning of the period, and
r the net return a country earns on it (or pays out, if B is negative). The
cash ow rB can be seen as the inow of payments to factors of production
(capital) owned by domestic residents, but operating abroad, minus the
outows of payments to factors of productions owned by foreign residents,
but operating in the country. Adding rB to GDP (the value added produced
within the border of country), we obtain the Gross National Product (GNP),
which thus includes also net exports of services from productive factors:
GNP = Y +rB
The current account is the dierence between GNP and absorption
CA = NX +rB = Y +rB (C +I +G)
Rewriting the above as the dierence between national savings and invest-
ment
CA = (Y +rB C G) I = S I
suggests that the CA is the result of intertemporal decisions.
Let T denote net taxes. For simplicity, lets assume (counterfactually) that
the public sector does not own foreign assets. We can distinguish between
private and public saving as follows
CA = (Y +rB C T) + (T G) I = S
private
+S
public
I
A budget decit, by denition, adds to external imbalances, unless it is
compensated by higher private saving, and/or lower investment.
The intertemporal view of the Current Account is backed by the theoretical
framework of consumption smoothing and saving models. If nancial markets
do not oer ex-ante insurance for all possible contingencies if markets are not
complete lending and borrowing in nancial markets oers opportunities to
nance temporary variations in output and spending while keeping consumption
at the level consistent with the permanent income. By way of example, a CA
decit is desirable if, ceteris paribus:
output is temporarily low (recession, natural disaster), government spending
is temporarily high
consumption rises in anticipation of higher income in the future
investment rises in anticipation of future protability.
A popular argument: Current account decits are less problematic when
associated with high investment as opposed to high consumption, since
investment raises the productive capacity of a country, hence its ability to
service its external debt in the future. Beware of this argument. Intuitively:
Investment may turn out to be non-protable ex post. By way of exam-
ple, South Korea had very high investment rates through the 1990s, but
in 1997 it suered a deep crisis, in part as a reection of over capitaliza-
tion in products (like computer chips) whose prices dropped faster than
expected.
The way imbalances are nanced (debt versus equity capital) matters.
With equity nancing, in case projects turn sour, losses are automatically
shared with foreign owners, reducing the burden of adjustment.
This is the recent evolution of CA in the world. In the past (before 1990),
emerging markets used to run large decits. In the mid-1990s, especially
after the crisis in East Asia in 1997-98, there is a shift in patterns. The US
runs an uninterrupted series of large decits.
In Europe, a low average CA however hides large intra-area dierences. For
the euro-area for instance:
It is quite dicult to rationalize the emergence of the large current account
imbalances in the world, especially run by the US, with the basic idea of
consumption smoothing, unless one is willing to assume that residents in
the countries in decits were persistently expecting very large income gains
in the future, raising their permanent income gains that however have
not materialized ex post.
More on this later.
Domestic saving can nance either domestic investment I (increasing do-
mestic capital) or the acquisition of foreign assets (increasing foreign wealth).
So CA = S I > 0 means the country is accumulating net foreign wealth
over the period. Using the time subscript t and t + 1:
B
t+1
B
t
= CA = Y +r
t
B
t
(C +I +G)
But B is the dierence between gross foreign assets and gross foreign lia-
bilities positions
B = FAFL
so that
B
t+1
B
t
= (FA
t+1
FA
t
) (FL
t+1
FL
t
)
where FA and FL are large portfolios of equities, debt, bank loans, deriv-
atives etc.
Here is the evolution of FA and FL in the US and the UK, as % of GDP 1950-2005
(http://www.aeaweb.org/annual mtg papers/2007/0106 0800 1301.pdf)
Here is the composition of FA and FL gross positions for the US, in % of GDP
(same source). Other includes lending and borrowing in foreign currency.
The composition of FA and FL gross positions for the UK.
The UK picture reects (a) the decline of the UK sterling as international
reserve currency in the early period of the sample, corresponding to the rise
in the dollar, but also (b) the emergence of the London as an international
banking center in the 1960s, with the growth of the market for the so-
called euro-deposits and eurobonds (deposits and bonds denominated in a
currency, say dollar or euros, dierent from the currency of the jurisdiction
in which they are traded e.g. dollar deposits traded in the London).
most of the banking transactions in London are hedged (the banks cov-
ered themselves from exchange rate risk), hence variations in the ex-
change rate do not aect the UK net position through this class of
assets.
The US instead has increasingly taken the role of the global banker of the
world. On the liability side, they sell short-term asset (bills and bonds)
mostly denominated in dollars, which are widely circulated and used for
international payments, or as collateral in lending/borrowing among coun-
tries. On the asset side, they purchase long-term assets (equities, direct
investment and bonds) mostly denominated in foreign currency.
This maturity-currency transformation (short-long, dollar-foreign currency)
has two key implications (to be discussed further below)
long-term assets tend to pay higher yields than short-term asset
when the dollar falls, the value of their external assets ceteris paribus
rise, improving automatically their net position.
Much of the FA and FL development is driven by banks and nancial in-
termediaries. Here is a picture by Hyun Shin, about the intermediation
role of European global banks in recent years (the implications of the
global/shadow banking system are still to be fully understood).
Lets focus on the return on net foreign wealth rB. This includes (a) income
from real and nancial assets (coupon from bonds, interest payments from
bills and deposits, distributed prots and dividends from rms etc.), in and
out the country; (b) capital gains and losses, and valuation eects due to
exchange rate movements if, say, the pound depreciates, the pound-
equivalent of a euro-denominated bonds rises.
With a large stock of outstanding FA and FL, the (b) component is poten-
tially much larger than (a).
the CA according to national accounting only records (a). However,
some institutions and academics have produced estimates of the CA
adjusted for changes in asset prices and the exchange rate. See, e.g.,
Lane and Milesi-Ferretti, The External Wealth of Nations, Mark II,
Journal of International Economics.
The graph shows the large dierences between the (a) the cumulative of CA
as measured by national accounting, and (b) an estimate of B adjusted for
valuation eects. www.aeaweb.org/annual mtg papers/2007/0106 0800 1301.pdf
The main message is that, because of the growth of FA and FL, looking
at the CA of a country as reported in national accounting may not give a
proper picture of its net foreign wealth evolution. The CA may be in decit,
when eectively the country is increasing its net position abroad.
Variations in asset prices and the exchange rate create large uctuation in
net wealth.
On average, however, the world interest rate has been steadily falling.
The importance of valuation eects is apparent in estimating the change in
national wealth per eect of the global crisis, which has coincided with large
movements in asset prices and currencies. Gourinchas et al. (2011) draws
the following map
2 Exorbitant privilege, monetary sovereignty, orig-
inal sin
While the US appears as the biggest loser from the global crisis, this country
has long been a clear winner in international markets. Specically, the US
had the (exorbitant) privilege of receiving a much higher return on its asset,
than it pays on its liabilities. Here are the most conservative calculations
by Gourinchas et al. 2011
1952 2009 1952 2009 1973 2009
return on US foreign assets 4.91 4.71 5.02
return on US foreign liabilities 3.42 3.46 3.40
dierence 1.49 1.25 1.62
This privilege is in part due to the dierences in the composition of US
gross foreign assets (Foreign direct investment, equities and long-term bond,
denominated in foreign currency) and US gross foreign liabilities (in large
part, short term dollar-denominated assets). Risky and long-term assets
typically pay a risk premium over short bills and bonds. However, this may
not be the whole story.
US assets clearly trade at a liquidity premium dollar denominated
assets are widely accepted and circulated.
the US may provide insurance against global catastrophic risk when
the global crisis hit, US markets remained quite attractive, even if the
crisis arguably originated there. International investors are willing to pay
a premium for safety.
Indeed, it pays to be the reserve currency of the world. Here is evidence showing
the decline in the privilege enjoyed by the UK when the pound became progres-
sively marginalized in the international nancial system. The table below report
the dierence between return on FA and FL according to a less conservative
estimate than reported above (see Gourinchas et al. 2007 for details), also for
a dierent period excluding the onset of the global crisis. As you see, despite
being an international nancial centre, the UK no longer gains high dierential
returns on its net foreign assets.
Return on FA-return on FL 1952 2005 1952 1973 1973 2005
US 2.33 0.26 3.61
UK 1.85 3.51 0.79
The UK has nonetheless retained full monetary sovereignty, dened as an in-
dependent monetary policy, in conjunction with the ability to issue liabilities
denominated in own currency (UK government and residents can borrow easily
in pound). Most countries in the world do not enjoy monetary sovereignty so
dened.
The original sin is the label Barry Eichengreen and Ricardo Hausmann use to
identify a key problem faced by countries where residents appear unable to issue
assets (borrow) abroad or even domestically in domestic currency. If one looks
at the statistics on the shares domestic currency-denominated bank loans and
international bond debt, it is apparent that the original sin aect virtually all
developing countries, regardless of their geographical location (for these coun-
tries, the above shares are close to 100 percent). Less so developed countries
and nancial centers.
The origin of the problem is heavily debated. Empirically, it is clearly but not
exclusively linked to a history of high ination and currency depreciation. Leading
models emphasize investors mistrust in the government, not to use depreciation
and ination to reduce the value of their national liabilities. Eichengreen and
Hausmann also argue that it may be partly due to the intolerance by international
investors, in dealing with more than a few currencies in their portfolios.
The essence of the OS problem is this: if FL are denominated in foreign currency,
a nominal devaluation of the currency implies that the value of debt in domestic
currency correspondingly rises. This is a negative valuation eect, that vastly
reduces the benets from exchange rate exibility.
When the exchange rate in a country subject to the OS depreciates, banks
that lend in domestic currency, rms that sell in domestic markets, and
households that receive income in domestic currency, will all experience an
increase in the burden of their debt relative to their incomes. Banks will go
either bankrupt, or will be forced to cut down on lending to x their balance
sheets; rms will nd it dicult to obtain credit; household will be forced
to save more, hence cut down spending.
Any potential output and employment gain in competitiveness from ex-
change rate depreciation, can be wiped out by these eects.
Technically, the OS problem aects the member of a currency union. If a
country in the euro area tries to restore competitiveness by lowering its sup-
ply prices and thus its income in euros, the burden of its euro-denominated
debt correspondingly rises.
In contrast, countries retaining monetary sovereignty can count on an op-
posite, stabilizing, eect of the exchange rate. Exchange rate depreciation
does not increase the burden of external debt for residents
lowers the international price of the countrys debt in international port-
folios.
In the world today, the reserve currency status of the US is still unchallenged.
Only a few countries enjoy monetary sovereignty. Most countries are aected
by the original sin.
3 International reserves
By an accounting identity, the current account balance corresponds to net
capital outows (if CA>0) or inows (if CA<0). The fundamental Balance
of Payments (BP) identity is
CA
t
+KA
t
= 0
whereas KA
t
is dened as the negative of the increase in net foreign assets.
The Balance of Payment records all economic transaction between domestic
and foreign residents, based on the identity above. Portfolio movements are
recorded only in the KA.
By way of example, when domestic residents purchase foreign assets, the
value of these will be recorded as a negative entry. If, to pay, they use
their domestic bank deposits, there will be a positive entry of the same
amount, corresponding to a rise in domestic bank liabilities.
In practice, you will nd:
CA+KA+ statistical discrepancy=0
where the last term is large.
If CA
t
+KA
t
= 0, what is a BP decit then? Separate the accumulation
of net foreign assets by the monetary authorities i.e. the accumulation
of foreign reserves by Central Banks and the Treasuries from the rest of
the capital account.
KA
t
= non reserve capital account + ocial settlement balance (OSB)
An increase in reserves corresponds to a negative entry in the OSB. The BP
is commonly referred to the negative of the second account
ocial settlement balance (OSB)
= CA
t
+ non reserve capital account
A balance of payments (OSB) surplus corresponds to an accumulation of
reserves; a decit to a loss of reserves.
The term BP decit is inherited from the days of xed exchange rates
and no capital mobility: with limited private nancing from abroad, a trade
decit would translate into a BP decit the monetary authorities had to
close (for the exchange rate not to depreciate) using reserves (gold and
internationally accepted assets denominated in dollar and a few other cur-
rencies) and/or obtaining credit by foreign central banks or the International
Monetary Fund.
Today, reserves are seen as an insurance against sudden stops of external
nancing by international investors, rather than a way to nance CA decit.
A large stock of reserves is meant to reduce a countrys vulnerability to runs
on its debt (with investors refusing to roll over credit).
The nancial need of a country during any given period is the sum of
current account decit, and the value of outstanding liabilities coming
to maturity in the period, that need to be rolled over.
A large stock of reserves means that a government can survive a sudden
drying out of credit by using its liquid reserve assets to nance the capital
outow.
This insurance comes at a cost: since reserves are held in the form
of liquid (short-term) assets, they pay a low interest rate, relative to
alternative investments.
What is puzzling is that, in many countries, IR are many times the yearly
nancial need of the country. Countries that use them during the nancial
crisis, quickly replenish their stock!
Balance of payments issues are recently debated in the euro area. This is
because, per eect of the global and the sovereign debt crises, the euro
area has been experiencing large capital ows across borders. At the same
time, the European Central Bank has been intervening heavily in support
of euro-area banks similarly to other central banks , to compensate
for a malfunctioning interbank market. As a results, when capital outows
give rise to domestic banks liabilities (recorded in the KA), these are no
longer towards private banks abroad, but with their own central bank (since
ocial lending is much cheaper than nance in the interbank market)
and, through this, to the central bank of the destination country.
In the euro area, by an accounting arrangement, credit/debit positions be-
tween national central banks give rise to accounting balances called Target2
balances, recorded bilaterally.
Through the mechanism described above, as private capital ow from, say, Spain
to Germany, during the crisis, the Bank of Spain ends up recording Target2
liabilities, the Bundesbank Target2 assets.
In an accounting sense, the Target2 like the OSB records ocial nancing
of the capital ows out of Spain, Italy, Greece, Portugal and Ireland; into
Germany and other northern countries. But the T2 entries are not true
bilateral liabilities.
By the euro-area law, any capital loss (or gain) on T2 balances is shared
among all the countries in the union. Only in the case of a systemic break
up of the euro, it is possible that Target2 accounting entries turn into actual
economic assets/liabilities of individual central banks
(http://www.cepr.org/pubs/policyinsights/PolicyInsight57.pdf).
Yet some authors, especially HW Sinn, argue that, via Target2, Germany
is disproportionally increasing its bilateral exposure to unsafe debtors and
therefore to default risk (http://www.voxeu.org/article/ecb-s-stealth-bailout).
4 The international monetary system
In the rst wave of globalization (ending with World War I), the world
operated under the Gold Standard:
convertibility of currencies into gold implied that the price of consump-
tion and investment goods was tight down by a relative (real) price,
so was the exchange rate between currencies, through the mint parities.
for the international monetary system to work, gold had to be free to
circulate across border, to ensure settlement of international payments.
Adjustment is conceptualized according to Humes model:
if domestic ination rises, the currency becomes overvalued in real terms,
causing an external decit (net exports drop), and thus a loss of gold re-
serves. This automatically translates into a monetary contraction, caus-
ing domestic goods prices to fall, so to re-establish competitiveness and
external balance.
this model disregards the capital account in the balance of payment. De
facto, central banks actively raised interest rates to attract international
capital and thus smooth adjustment and prevent gold losses in the short
run.
World War I: the nancial strain of the war ruled out convertibility and
free circulation of capital. Attempts to go back to the gold standard in the
interwar period failed or created unnecessary strain (see the UK experience).
The design of the new system in Bretton Woods (1944) is dominated by
skepticism about oating rates, dictated in large part by the experience of the
pre-WWII years, when the world broke up into political and economic regions
in conict between each other. Countries imposed taris on goods; some
devalued their currencies with the goal of gaining competitive advantages.
The international monetary system was meant to foster the growth of
output and free trade among countries.
A return to the gold standard was deemed impractical and inconsistent
with the new geo-political order. It is worth noting that, in part per
eect of the war, gold reserves were mostly concentrated in the US.
The prevailing thesis was that exchange rate variability should have been
avoided since (a) volatility in relative prices is bad for trade and invest-
ment, (b) speculation can create misalignment of relative prices, which in
turn generate costly reallocation of resources across sectors (R. Nurske).
The solution was to design a new system as a Gold exchange standard:
(a) xed but adjustable parities, (b) gold convertibility restricted among
central banks, (c) capital controls. The dollar was at the center of the
system, providing the nominal anchor: US authorities committed to keep
the dollar value xed in terms of gold. As mentioned above, the US had
large gold reserves, to back their currency.
Realignments were possible in the presence of fundamental disequilibrium
(never exactly dened in the IMF articles).
Fiscal expansions could stabilize employment (internal balance) only at
the cost of current account decits (external imbalance). The scope for
monetary policy was limited because of the exchange rate target.
In particular circumstances of disequilibrium (usually, per eect of cu-
mulated high ination over some years), a country could devalue, as
to restore both internal and external balance.
To prevent frequent devaluations from undermining the credibility of the
xed exchange rate system, realignments of the exchange rate parities
were subject to multilateral surveillance.
Three problems with Bretton Woods
1. Adjustment problem. De facto, only countries with balance of payment
decits were held responsible for adjustment; hence the system had a reces-
sionary bias:
the decit countries had to cut demand to restore external balance, while
the surplus countries could simply target full employment, leaning against
excess demand. On average, demand would fall short of full employment.
2. Trin dilemma: should the US target convertibility keeping the growth
of international dollar liabilities in line with gold reserves; or should the US
provide international liquidity as needed running BOP decits in line with
the growth of world trade?
If the US pursued the rst option, there could be a scarcity of interna-
tional means of payment, with detrimental eects on trade; if the second,
dollar convertibility could be compromised.
Proposed solution: a new means of international settlement, the Special
Drawing Rights SDR.
3. Ination in the US, associated with the budget costs of the Great society
programs and especially the US wars. With gold xed at $35 per ounce,
ination meant that gold became progressively undervalued relative to
goods.
The US could not be expected to run negative ination to correct past
gold undervaluation.
On the other hand, a devaluation of the dollar in terms of gold, without
addressing the domestic ination problem, would have simply destroyed
the credibility of the dollar as anchor of the system.
As a temporary solution, the gold market was segmented into two tiers, with
separation of monetary gold (in the vaults of central bank), and private gold.
Convertibility was suspended on August 15 1971 by president Nixon, followed
by attempts to rebuild a coordinated system (Smithsonian agreements). But
the oil shock fuels large speculative attacks and exchange rate volatility.
The reform of Bretton Woods
Without dollar gold convertibility, the system had lost its original nominal
anchor. A key reason for participating in system of xed exchange rate was
no longer there.
The relatively high ination in the US through the 1970s made it clear
that the dollar could not provide the nominal anchor for the system.
Germany for instance was not be ready to import ination from the
US.
In 1978, the second amendment to the articles of agreement of the IMF es-
tablished that xed exchange rates were no longer the norm. In the reformed
system, each country can choose its preferred regime.
Without the balance of payment constraint of the xed exchange rate, some
countries felt they could move more easily towards capital account liberal-
ization, to complement a process of domestic nancial deregulation: in
response to capital ows, in alternative of using reserves, they could simply
let the exchange rate depreciate.
In any case, with increasing economic integration and domestic deregu-
lation, capital controls were increasingly dicult to implement.
The new system of at monies could have resulted in years of ination variability
and chaos. Remarkably, the world steadily moved to an equilibrium with low and
stable ination.
The monetary and currency chaos in the 1970s had convinced many economists
that exchange rate variability was primarily a monetary phenomenon. Restoring
monetary stability the argument went would restore exchange rate sta-
bility. The experience of the last decades show that this thesis was not right.
Exchange rates remain variable, in nominal and real terms, despite low ination
and monetary stability (see appendix).
Exchange rate arrangements in the post BW era.
Exchange rates remained exible between the US, Europe and Japan.
Within Europe, continental countries embarked in a long journey towards
monetary unication (European Monetary System, with its Exchange Rate
Mechanism), achieved at the end of the 1999. Other countries eventually
opted for monetary independence, adopting ination targeting strategies for
monetary policy.
Emerging countries (arguably because of the original sin problem) remained
in some form of xed exchange rate, ranging from hard pegs and currency
boards to managed pegs, targeting either the dollar (or recently the euro),
or a basket of currencies.
With progressively globalized capital markets, the new system endured a large
number of currency, sovereign and nancial crises of mostly regional nature,
although with increasingly strong global eects. Since the end of the 1990s,
the emergence of large global imbalances, and the growth of new large economic
and monetary players in the global scene raise issues in the stability of the system:
what would it take to foster adjustment? Will the dollar remain the dominant
international reserve currency? Should capital mobility be curbed? The eruption
of a large global crisis in 2007 is a clear indicator that the answer may require
some radical change.
5 Conclusions
We have seen that the landscape of the international nancial system is currently
characterized by:
Persistent CA surpluses/decits (i.e. S-I imbalances) across macro regions
and within regions (the euro area).
Emerging markets, with higher growth prospects, are running surpluses,
when, according to standard current account-models, they should be
expected to run decits.
Much larger rise of Gross Asset and Gross Liabilities, increasingly driven by
global banking.
Because of the large stocks of Gross Assets and Liabilities, the value
of net positions are very sensitive to capital gains and losses on assets
(including currency uctuations).
Countries dier in the composition of their portfolio of foreign asset/liabilities,
which systematically aects the net capital income accruing to a country.
The US benet from persistently large positive dierentials between the
income this country pays on its foreign liabilities, and the income it
receives on its foreign assets.
A few countries enjoy monetary sovereignity, i.e. they issue debt denom-
inated in own currency.
Most countries are aected by the original sin, i.e. they issue debt
denominated in foreign currency.
Especially after the Asian Crisis, emerging markets have accumulated enor-
mous stocks of international reserves.
International monetary and nancial systems may dier in their ability to prevent
the build up of disruptive imbalances ex ante, to reduce the vulnerability of the
system to shocks, and foster adjustment with minimum costs. The facts just
described are at the same time indicators of the accumulation of imbalances in
the current system, and constraints on the way the current system will be able
to metabolize them.
These facts deeply challenge the way prevailing models conceptualize macro-
ecomic interdependence. In the next two blocks of this course, we will reconsider
these models, in view of their inuence on the current policy debate, in order
to extract valid lessons, but also to assess their limits. In a nal lecture, we will
look at possible directions to meet the challenge.
Readings
From K. Pilbeam. 2006. International Finance, Palgrave, III edition.
On exchange rate denitions: Chapter 1, Sections 1.1-1.6. On accounting and
balance of payments: Chapter 2. On the international monetary system: Chapter
11. On the PPP discussed in the appendix: Chapter 6, sections 6.1-6.8 (or
equivalent chapters from your intermediate macro book)
Krugman Obstfeld Chapter 18 and 19 (19 and 20 the new edition with Melitz).
Appendix: Exchange rates, goods prices
The nominal exchange rate is the relative price of two currencies (or basket
of currencies). Dene E in terms of units of domestic currency per unit of
foreign currency an increase is a nominal depreciation.
The real exchange rate is the relative price of consumption in two dierent
countries (or regions). Let P denote the domestic price of consumption
(CPI) in domestic currency, P

the foreign CPI in foreign currency. The

real exchange rate is
EP

P
For a given E, domestic ination growing above the foreign one causes real
appreciation.
Domestic prices are much less volatile than the exchange rate, and especially
import prices remain rather stable in local currency.
The nominal and the real exchange rate are highly correlated (.9-1).
Exchange rates are quite volatile, although less than the stock market.
ER volatility is mostly at business cycle and higher frequencies: exchange
rates tend to exhibit long and persistent swings. The following graph is
taken by Rabanal and Rubio (2010), showing the real eective exchange
rate for the pound (calculated against an average of trade-partners), and its
spectrum.
Purchasing power parity (PPP) states that, once converted in a common
currency, the price of an identical basket of goods should be the same across
borders
EP

= P
In relative terms, the same law states that the rate of depreciation in the
bilateral exchange rate between two country should be identical to their
ination dierentials.
The main idea is that, as prices of goods move out of line across dierent
locations, economic agents take advantage of arbitrage opportunities:
they buy where prices are low, and sell where prices are high, until price
dierentials (net of arbitrage costs) disappear.
While PPP is clearly violated in the short run, the consensus view is that it
tends to hold over long horizon, although adjustment occurs at a very low
speed.
Deviations from PPP, especially in the short run, may not come as a surprise,
since many goods in the consumption basket are not traded internationally
(their value added is small relative to transportation costs, e.g. low quality
services). So, there is no scope for arbitrage.
Yet the evidence shows that also the law of one price (LOP) for traded
goods is systematically violated in the short run.
LOP: once converted in a single currency, the price of a particular good
h must be the same across locations
Ep

(h) = p(h)
Some (by no means all) studies suggest that deviations from the LOP dis-
appear faster than deviations from PPP.
The terms of trade TOT is the relative price of imports in terms of exports.
price of imports
price of exports
Evidence across countries suggests that
the real exchange is correlated with the terms of trade, although not
perfectly so: a depreciation tends to make the TOT weaker.
the real exchange rate is more (twice) volatile than the terms of trade.
The nominal exchange rate is weakly correlated with the price of imports,
suggesting that nominal depreciations do not automatically raise the price
of foreign goods in the domestic economy.
Various studies indeed show that the exchange rate pass through on domestic-
currency prices of imports (ERPT) is:
well below 100 percent for prices at the border (i.e. ex taxes, transporta-
tion, distribution margins etc.)
very low at consumer-level
dierent across industries
increasing, but still incomplete, over long horizons.