W3: Environment, Institutions and the rules of the game

GATT, the IMF and the World Bank

“So long as capitalism exists, Marx will be read as its most astute analyst. If capitalism ceases to exist, he will be read as its best critic.”

The Second World War and early post war years saw the most sustained attempt in the 20th Century to reconstruct the international economy. The objectives and instruments, success and failures of this effort form a vital backdrop to understanding of the world economy after 1945.

The impact of World War two was to further accentuate the dominance of the American economy over international relations. Being forced to fund the war effort of countries such as Britain, then actually to enter into the war itself ensured that after the war American foreign policy was to play an unambiguously large role in determining the post-war settlement.

American foreign policy was also forced to alter in the process of the establishment of the economic dominance of the American economy. America itself had strong domestically originating isolationist tendencies. Yet by 1945 it was widely recognised that American economic isolationism was no longer feasible, indeed it had been an element of the failure of the inter-war economy and the outbreak of World War two.

American economic and political hegemony within Europe, and internationally, was now established. With this hegemony also came the demise of London as a centre for political hegemony.

Lessons of World War two

The dominant explanation for the slump of the 1930s and the outbreak of World War two began with recognition that economic failure was a central component.

1) Economic instability was caused by the emergence of economic nationalism, expressed through trade restrictions - Imperial Preference through Ottawa Agreement.

2) Competitive currency deprecations - First re-establishment and later collapse of gold standard.

The post-war settlement dictated that a new economic order should be created with a mutual interdependence between economies at its heart. This interdependence should itself be based upon multilateralism in trade and currency convertability. Linked to convertibility was a stable regime of monetary exchange.

Multilateralism in trade it should be noted does not mean free trade - No economy was prepared to abandom important restrictions. Multilateralism meant more precisely trade free from discriminatory tariffs, i.e. tariffs where applied should be applied across the board and not too individual nations or particular items of trade.

Currency convertibility was understood to mean not an absence of controls over currency exchange but again a removal of restrictions which applied discriminatorily to foreign holders of each currency. Finally more stable exchange rates did not mean entirely fixed exchange rates, as the gold standard had been - however there was not an established alternative put forward.

The Neo-liberal model of economics leaving the market to regulate economies was in tatters. Instead a new economic orthodoxy emerged which emphasised government regulation of the economy. The managed economy didn’t replace the market rather it facilitated the market by establishing a ‘rules based system’. Keynesianism was the economist most associated with the development of the managed economy. Even in countries where Keynesianism was rejected it was still the case that government’s role increased and acted to regulate the macro economic environment.

• what went wrong before the war:

  • the world economy crashed in the 1930s (The Great Depression)

  • countries tried to protect themselves by trading only with their own colonies and raising tariffs (trade taxes). This is called economic nationalism

  • they also tried to gain an advantage by lowering the value of their money (competitive currency devaluation) which created even more instability

  • the gold standard (a system where money was tied to gold) fell apart, making currencies even more unstable.

• lessons learned after the war: After the war, leaders realised that economic cooperation was key to preventing another crisis or conflict.

  • encourage mutual interdependence between countries

  • support fairer trade, where countries didn’t play favourites (called multilateralism). This doesn’t mean no tariffs, but tariffs should be fair and the same for everyone

  • allow countries to convert currencies more easily and fairly

  • create stable exchange rates for currencies - though not as strict as the old gold standard.

• a new economic model

  • the old idea that the market should be left alone to fix itself (laissez-faire) was no longer trusted

  • instead, countries agreed government should help manage the economy.

  • this didn’t mean governments controlled everything - jus that they made rules to help the market work better

  • Keynesian economics, named after economist John Maynard Keynes, became very influential. It said governments should spend money and create policies to keep the economy stable

Establishment of Bretton Woods, IMF, the World Bank and GATT

Bretton Woods

1945 signing of Bretton Woods Agreement, establishment IMF and the World Bank (International Bank for Reconstruction and Development, IBRD) acted as an institutional embodiment of these ideas underpinning international finance. The International Trade organisation super-ceded by the General Agreement on trade and Tariffs and GATT was the embodiment of the international trade ideals.

Bretton Woods was an agreement on convertibility of currencies based upon a fixed by adjustable exchange rates based upon the $. These fixed rates were also to be based upon removal of exchange controls. This in fact did not happen. The disaster of making sterling convertible during the summer of 1947 resulted in Britain, as elsewhere, abandoning attempts to achieve convertibility until 1959. It can thus be said that the Bretton Woods system did not come into effect until 1959.

10% peg in cases of ‘fundamental disequilibrium’.

Convertibility in the late 1950s came piecemeal but when it came there also followed a rapid integration of financial markets as European markets expanded and FDI increased. The result was the growth of what became known as the Eurodollar market with payments and trade outside of the US being carried out in $.

The strength of European economies and the burden of arms expenditure saw the US develop large capital outflows. Whereas sterling had been the weak currency in the late 1940s the $ became so in the late 1960s.

By 1971 the Smithsonian agreement saw the dollar gold rate abandoned. Other currencies were revalued against the dollar. By 1973 this new agreement had collapsed and de-facto floating exchange rates had emerged - at this point the £/$ rate entered our news programmes.

BW Summary

In 1944, world leaders met in Bretton Woods, USA to design a new global financial system to avoid the chaos that followed World War one and the Great Depression.

They agreed to:

• make trade and money systems more stable and cooperative

• create two big institutions to help:

  • The International Monetary Fund (IMF) to help countries with financial problems

  • The World Bank - to help rebuild and develop economies (especially in war-torn countries)

Trade: They also worked on a global trade system to avoid unfair trade practices. The first version was International Trade Organisation, but this was replaced by GATT (General Agreement on Tariffs and Trade) which later became the World Trade Organisation.

Currency system:

• countries agreed to fix their currencies to the US dollar, and the dollar was tied to gold. This was called a system of “fixed but adjustable exchange rates”.

• the idea was to keep currencies stable but allow some adjustment (up to 10%) if needed due to serious problems (called “fundamental disequilibrium”)

However there were problems early on:

• countries were supposed to make their currencies easily exchangeable (convertible), but that didn’t happen right away

• Britain tried in 1947 and it went badly - there was a run on the pound - so they gave up and didn’t try again until 1959.

• So, the Bretton Woods system didn’t really start working until 1959.

After 1959:

• once currencies became more convertible in the late 1950s:

  • financial markets grew quickly

  • FDI increased

  • The Eurodollar market grew - this meant that dollars were being used for trade and banking outside the US

But trouble returned in the 1960s:

• the US was spending a lot on military and aid, causing lots of dollars to flow out of the country

• the dollar became weaker, and other currencies became stronger

• this shift echoed how the British pound was weak in the 1940s

End of Bretton Woods:

• In 1971, the US ended the dollar’s tie to gold (this was called the Smithsonian Agreement).

• other currencies were adjusted but the system didn’t hold

• by 1973, the whole fixed exchange rate system collapsed

• from then on, we entered the world of floating exchange rates, where currency values are set by the market

IMF

The British had supported the setting up of the International Monetary Fund and the calling of the Bretton Woods Conference in 1941. It was recognised that the strength of the dollar was such that sterling could not survive on its own and be convertible without an international system for regulating finance.

Bretton Woods established the IMF with a fund of $8.8b, the currency scarcity clause was embodied within its clauses (giving lending priority to debtor nations). Debtor nations would receive advice and funding, conditional upon following the advice which would resolve the disequilibrium. Although conversely ambiguity existed over exactly what influence the IMF could impose on creditor countries.

Again the IMF was never tested in the immediate post-war years as US government aid, known as Marshall Aid, was conditional upon countries not applying to the IMF for support. Lao the setting up of a bank aimed at development and re-construction - the International Bank for Reconstruction and Development IBRD was the mechanism by which reconstruction could be financed in order to prevent the IMF from being swamped in the immediate aftermath of reconversion to peace.

why Britain supported Bretton Woods:

• during WW2, Britain knew its currency was weak compared to the strong US dollar

• British leaders supported creating a global financial system to help manage currencies and support weaker ones, like the pound

• that’s why they supported the idea of an International Monetary Fund and the Bretton Woods conference which was planned as early as 1941.

What the Bretton Woods Agreement created:

• the IMF

  • set up with $8.8b

  • its job was to help countries with trade and currency problems

  • it focused especially on helping countries in debt

  • these countries could borrow money if they followed adivce on how to fix their economic problems (like spending less or managing inflation)

  • there was less clarity on how to deal with creditor countries (those with a trade surplus or more money)

• the IBRD

  • focused on rebuilding countries after the war

  • it was meant to finance reconstruction so that the IMF wouldn’t be overwhelmed by all the requests for help right after the war

Why the IMF wasn’t used much right away:

• in the years right after the war, the US provided financial help directly through “Marshall Aid”

• a condition of receiving US aid was not using the IMF, so countries didn’t really turn to the IMF until later

Britain supported Bretton Woods because it needed a global safety net for its weaker currency. The IMF was created to lend money to struggling countries, and the IBRD was created to help rebuild economies. In the short term, the US took the lead in helping Europe through direct aid, but the system laid the foundation for how the world would manage international finance in the long run.

GATT

Commitments to multilateralism and currency convertibility ushered in negotiations of, first the International Trade Organisation and then its successor the General Agreement on Trade and Tariffs, whose aim was to reduce tariff protection. While the ITO agreements were minor and largely failed, the GATT negotiations continued to make piecemeal advances in 1963-7 the Kennedy Round saw wider reductions in tariff protection.

As we are well aware GATT agreements continue to be exhaustive and difficult to achieve. The latest Uruguay round highlighted the widespread continuance of both tariff and non-tariff barriers to trade.

Nevertheless multilateral free trade never materialised instead trading blocks emerged: Sterling area, EFTA, common market and NAFTA.

In 1955 GATT is replaced by the World Trade Organisation to finally introduce global trade agreements. Thus it took 50 years to achieve the trade related outcomes of the Bretton Woods Agreement.

The goal: After WW2, countries wanted to avoid the trade problems that helped cause the Great Depression and the war, so they aimed to:

• reduce tariffs (taxes on imported goods)

• encourage fair trade between countries

• avoid trade discrimination

The first attempt was the International Trade Organisation, but it didn’t succeed. In its place came the General Agreement on Tariffs and Trade.

• GATT helped countries negotiate trade deals and reduce tariffs

• it wasn’t perfect, but it made slow progress over time

Progress in trade:

• one important step was the Kennedy round (1963-7) of GATT talks, where many countries agreed to lower tariffs

• but trade talks under GATT were always long and complicated, and countries still used other barriers to protect their industries (called non-tariff barriers)

Even though the goal was global free trade, countries started forming trading blocks instead:

• Sterling Area (British linked economies)

• EFTA (European Free Trade Association)

• Common Market (which became the EU)

• NAFTA (North American Free Trade Agreement)

These blocs traded mostly within their own groups, rather than truly globally.

In 1995, the World Trade Organisation replaced GATT. The WTO was created to better manage international trade and finally achieve what Bretton Woods had aimed for 50 years earlier: a system of global trade rules.

GATT was a stepping stone to fairer world trade. It made progress, but slowly and not always successfully. Global free trade still hasn’t fully happened, but the WTO is now the main group trying to make that vision a reality.

Britain and the New World Order

These pillars of the post-war international economy was not obviously conducive to British trading interests. The British economy had been one of the main culprits in the break-up of international trade. Britain retained significant discriminatory tariffs within a system of Imperial Preference, whereby trade within Empire was subject to no or reduced restrictions.

The contradiction between the British view of its interests in international trade and the hegemony for a New World order was apparent from the earliest days.

In 1941 the statement of Allied war aims – the Atlantic Charter explicitly drew attention to this contradiction.

The post-war settlement would endeavour ‘to further the employment by all peoples of access o equal terms to the trade and the raw materials which are needed for economic prosperity’. The British expressly had inserted the phrase ‘with due respect for existing obligations’.

The 1942 Mutual Aid Agreement, granting lend-lease, was still more explicit in the acceptance of a new economic order. Article VII stated that Britain would work towards the abolition of trade discrimination. However, there was disagreement on whether or not this referred to Imperial Preference.

British concern over and reluctance to accept the US principles of the post-war world were not simply based upon narrow self interests of Empire but were also located in the acceptance of Keynesian demand management within the Treasury and British economic circles.

Full employment was a cornerstone of the Keynesian world view – an over zealous commitment to free trade had been a focal point of the Keynesian attack on British economic liberalism and the return to the gold standard at an artificially high rate.

Keynes was sceptical of the US commitment to full employment. Despite the New Deal Keynesian views were not explicitly accepted within the US.

Under these conditions any post-war slump within the US with the international repercussions, was understood to present British economists within difficulties of maintaining a commitment to full employment.

Hance we have a more complex picture of why British policy makes should have been less than enthusiastic in adopting the ideology of American economists on issues relating to non-discriminatory trade.

The second element of post-war settlement was the creation of currency convertibility and more stable exchange rates. Here the British had been making the running with Keynes drafting proposals for a Clearing Union for payments in international trade as early as 1941.

Explicit within the discussions which followed was the presumption that Britain would continue to play a major role in the financing of the world economy. As Keynes put it ‘however, hard up we may be for the time being, we – on the assumption which underlies all our post-war plans – shall be standing on the top of the world, one of the two or three masters of the future.’

After WW2, countries worked together to build a new global economy that would encourage fairer trade and more cooperation. But Britain had a hard time fitting into this new system.

Britain’s trade system didn’t match the new rules:

• before the war, Britain used a system called Imperial Preference - this meant it gave special trade deals to countries in its empire, like India or Canada

• the new world trade system wanted non-discriminatory trade, meaning all countries should be treated equally, no special deals

• this created a conflict - Britain wanted to protect its empire trade, but the US and others wanted global fair trade

Agreements forced Britain to change:

• in 1941, the Atlantic Charter (a statement of Allied war goals) said that all countries should have equal access to trade and resources

  • Britain added a clause to protect its current empire agreements (“existing obligation”)

• in 1942, the Mutual Aid Agreement (part of the US Lend-Lease program) asked Britain to work toward ending trade discrimination

  • But it wasn’t clear if that meant ending Imperial Preference, which Britain didn’t want to give up

It wasn’t just about empire:

• British leaders weren’t just defending the empire - they were also trying to protect jobs and avoid economic problems

• Britain had adopted Keynesian economics, which focused on:

  • government support for full employment

  • avoiding economic crashes through careful management of spending and demand

• many in Britain didn’t trust the US to do the same. They feared that if the US had a recession, it would hurt the UK’s economy too.

Currency and payments - Britain had a vision too:

• Britain also had ideas about how the world’s money system should work

• In 1941, economist John Maynard Keynes proposed a “clearing union” to help countries manage payments and trade smoothly

• Britain hoped it would still be a leading economic power after the war, helping shape the economy

• As Keynes said: “However hard up we may be… we shall be standing on top of the world, one of the two or three masters of the future.”

Britain wanted to keep its empire trade deals, but the new world system wanted fair trade for all. It also feared that too much free trade could cause unemployment at home. Britain had its own plans for global finance and wanted to be one of the world’s economic leaders, not just follow the US.

International trade

International trade and finance ran together in the explanation of the economic crisis of the 1930s and the outbreak of World War 2.

While Britain was accused of creating instability by being a major violator of the inter-war trade system America was accused of creating instability within the international finance sector. As the major creditor nation with large trade surpluses America had sucked in international finance, leading to a severe worldwide dollar shortage. Without creditor nations exporting capital the post-war world would continue to suffer from liquidity crises. And Britain as a major debtor nation would in particular face continued difficulties.

Any post-war financial settlement needed to solve the problem of creditor nations. American proposals for a Stabilisation Fund accepted this view. The scarce-currency clause gave priority of access to funds to economies in deficit.

The proposal to establish the International Monetary Fund was published in April 1944. The IMF fund was set up, however, not as a creditor fund but only as a subscription-based fund – which went someway to undermining the scarce-currency clause as funding was now limited.

Economies had to pay into the Fund before extracting finance – yet debtor nations were clearly groping to be at a disadvantage in keeping up payment commitments.

Access to IMF funding was also to be ambiguous – whether it was free (the British view) or conditional (the US view).

The IMF agreement also provided economies with the right to unilaterally introduce 10% devaluation without advanced notice and agreement from the fund in cases of ‘fundamental disequilibrium’ in balance of payments.

Thus, with the IMF and Bretton Woods came an access fund to reduce balance of payments crisis and a system to maintain international monetary liquidity.

However as Gardener (1969) Sterling Dollar Diplomacy (p. 143) has suggested differences of opinion were still apparent.

‘The British appeared to regard the IMF as an automatic source of credit; the Americans seemed to consider as a conditional provider or financial aid. The British emphasised their freedom to maintain equilibrium by depreciation and exchange control, placing on creditor countries the main burden of adjustment; the Americans looked forward to the early achievement of free and stable exchanges, specifically rejecting the suggestion of any one-sided responsibility on the United States.’

Britain was essentially forced to adopt the American view of convertibility and non-discriminatory trade at the end of the war as the condition for granting aid after the end of lend-lease. The short-term consequences of this were significant. While Imperial Preference continued convertibility was attempted in 1947 and abandoned within weeks.

Alongside international moves towards reduced tariff barriers came European moves towards greater economic integration.

Just as British policy was to resist multi-lateralism on the grounds that Imperial Preference provided a protected market for British trade so too was Britain opposed to the creation of a Common Market within Europe which required members to adopt identical tariff barriers for trade outside the common market.

In 1945 at the time of the negotiations over the US Loan Agreement, Britain had no political alternative but to align itself alongside America. It was hardly going to join an East European bloc and neither did the Commonwealth represent a third way – although some including Ernest Bevin MP and Minister in the 1945 Labour Government believed that nuclear weapons and the Empire provided the opportunity.

Economically what alternatives existed to the acceptance of American hegemony. Economic catastrophe, ‘starvation corner’ in Keynes words, would have resulted without US aid both to Britain and the rest of Europe. The American Loan negotiations of 1945-6 determined the wider view of Britain’s position within the world.

The aim of achieving Great Power status and the belief in a ‘special relationship’ ensured that Britain was to maintain a closer link with the Commonwealth and the United States than with Europe.

Importantly, these comments are made in hindsight. It was far from obvious that the relative decline of the first half of the 20C was inevitably to continue.

The burden of the part, Empire and aspirations to great power status should not be seen as so irrational. Britain was a partner, all be it an unequal partner, in the reconstruction of the world economy after 1945. Its military and foreign commitments were important in defining the barriers of the post war order. Troops were used in Greece in 1946, Korea in 1951 etc. – great power status was not simply a pipe dream for policy makers.

Neither was Britain incapable of removing itself from Empire. Britain withdrew from India in 1947.

However, it came at an important cost – in shortages of international currency – dollars. This entailed an economic reliance upon America for aid and accepting the conditions imposed upon that aid.

In 1973 Bretton Woods mechanism for exchange rate, stability collapsed and Britain (and the world economy moved from floating exchange rates). The turmoil of the 1970s needs to be understood as the fall out from what was termed the ‘Golden Age’ of demand management. The readjustment from wartime combined with the growth and stability of the world economy derived in the post-war settlement and the dominance of macroeconomic Keynesian demand management.

Slavery, Colonialism and the origins of capitalism

Coerced Labour

It’s existence historically and in contemporary economy is utilised whereby low level of technology exists, and mass of labour replaces capital.

Indentured labour existed in the early migration patterns and the development of industry.

Child labour existed and still exists in areas of newly developing technologies; agriculture in subsistence farming of cash crops - cocoa and textile production in the twentieth century.

Extractive industries also utilised child and indentured labour.

Mining and textiles in the UK and legislation restricting use of child and indentured labour in the Factory Acts in 1830s.

1802 Health and Morals of Apprentices Act seeking to address use of indentured children in cotton mills.

1819 Cotton Mills and Factories Act prevented children under 9 being employed in the cotton industry.

1833 Factory Act establishing enforcement mechanism of Factory Inspectorate, restricting night working for those under 18 and required education for children working in factories. Barred children under 9 being employed (with the exception of the silk industry).

Factories Act 1844 and 1850 now extended provision to women and later barring women from night work.

The collapse of the family in early urbanising and industrialising Britain led to actions to ensure the workforce could be reproduced. Surplus labour from agriculture, which had supplied the towns with labour but was also emigrating to the new world, forced industrialists to seek to stabilise and reproduce the workforce.

Chattel slavery and the development of the British economy

Transatlantic Triangle Slave Trade

1690-1830s saw between 10-12 million Africans enslaved and transported across the Atlantic to work on the new plantation colonies of the West Indies and Americas.

The Triangular trade took manufacturers from Britain to West Africa where they were traded for slaves. These were then transported across the Atlantic, sold into chattel slavery and the proceeds bought raw cotton, tobacco, sugar and other raw materials and precious metals used in British industry.

Adam Smith again attacked the development of mercantilist interests in the slave trade. For Smith the ban on manufacturing in the colonies was ‘a manifest violation of the most sacred rights of mankind… impertinent badges of slavery imposed upon them, without any significant reason, by the groundless jealousy of the merchants and manufacturers of the mother country’ (quoted in Eric Williams, Capitalism and Slavery, p. 107)

Cotton imports rose three fold between 1700-1780, exports of finished cotton goods 15 fold. Between 1700-1780 shipping doubled, exports trebled. All measures of economic activity, urbanisation and wage labour followed similar patterns.

Slavery’s Abolition

It was an economic decision to abolish slavery combined with potential for slave revolts. Britain’s industrial revolution was well under way by the 1830s. Manufacturers not simply cotton were now the developing focus of industrialisation. Trade with the rest of the world was shifting the balance of power.

In Haiti, a slave revolt led by Toussaint L’Ouverture from 1789 through to 1791 led to Haiti’s independence in 1804. The American declaration of independence of 1776 and war with Britain until 1783 overthrew mercantilist control of north America. American industrialisation over the next 80 years until the civil war again saw free-wage labour emerging in the north but chattel slavery continuing in the south. The gap between the two systems of labour control and production grew until the civil war and slave rising in the south.

Coerced labour was inefficient, it led to poor quality work, tool breaking and exhaustion of the soil. Whereas free waged labour permitted specialisation, more complex production process and growing output.

If we return to the painting for Adolf Menzel we can see the skill and co-ordination involved in iron making.

David Montgomery’s description of the “Managers brain under the workman’s hat” in The fall of the house of labour: The workplace, the state and American labour activism, 1865-1925

The regular Saturday night meeting of Lodge No. m of the Rollers, Roughers, Catchers and Hookers Union stirred with excitement on June 27 1874.

That evening a committee of four members had brought before the meeting a report of utmost importance. They had met with superintendent Christopher Lewis of the rolling mill to discuss a contract for what was described in the lodge’s minutes as “the new mode of working: namely reheating”. After sections of iron “muck bar” had been heated in gasfired soaking pits under the watchful eyes of experienced heaters, they would be wheeled on buggies to the rolling mills on which these workers would fashion them into rails. Handling the bars with large tongs, as they were forced back and forth through the rolls a dozen or more times (with occasional trips back to the pits for further heating) would require full crews of thirteen men, and the superintendent had offered the men $1.13 per ton to do the work.

The minutes of the discussion that followed that report reveal a great deal about work relations in late nineteenth century heavy industry. The union members soon accepted the company’s offer… each worker states his own price. When those prices were added up, they produced a total that was 31 cents higher than the company’s tonnage offer. By careful revision of the rates for the buggymen, whose work was to transport the materials to and from the rolls, a complete scale was finally devised. The roller who adjusted the space between the middle roll and those below and above it for each successive pass and also checked the products size and shape as it developed, was to receive 19 cents per ton, and the rougher down, who helped him hurl the hot bars into the mill’s front end, got 10 cents. The two men on the other side of the rolls, who caught the emerging bar and forced it back through the upper set of rolls, were the catcher, who got 9 cents, and thr rougher up who earned 13. The hookers, who helped move the bars to alignment before the proper grooves on the rolls, were to earn 8 cents each. The runout hooker and the two runback buggymen, who moved bars about off the mill, only got 5 cents apiece, but more was to go to the gang buggyman and his helper, whose task it was to bring the heated blooms into position to be rolled. They were accorded 13 cents, to be divided between themselves.

Purchasing Power Parity

What is PPP

• Law of One Price - identical products should sell for the same price everywhere, as people could make a riskless profit by shipping goods from locations where the price is low to locations where the price is high

• the purchasing power of a unit of currency should be the same everywhere

• price of a commodity/basket equalises across countries when expressed in a single currency.

• method for testing theory:

  • express relative prices in same currency

  • overvalued or undervalued?

  • explain any discrepancy re LoOP

• Absolute PPP: The same basket of goods and services should cost the same everywhere

• the PPP implied exchange rate between two currencies

What is the Real Exchange Rate?

• RER measures relative purchasing power of currencies at prevailing nominal/market exchange rate

  • equal to 1 if LoOP (i.e. PPP) holds

  • “The [RER] is the nominal [or market] exchange rate (domestic price of foreign currency) multiplied by the ratio of national price levels (domestic price level divided by foreign price level)” - Taylor and Taylor, 2004, p. 141

• RER + ER X (P_D / P_B)

• ER = Dollars/pounds

Short run vs. Long run

• PPP can serve as a guide for long-term expectations of exchange rate movements

• PPP has limited utility in forecasting short-run fluctuations in the currency market

Why doesn’t PPP work?

• transportation costs and other costs associated with trade

• trade barriers (tariffs, quotas, non-tariff barriers)

• nontradeables

  • barriers to migration

• sticky wages and prices (long-term contracts, menu cost)

• pricing to market by business

• measurement problems

• local costs and taxes

National Poverty line in India

• in the spring of 2011, the government of India argued before the Indian Supreme Court that 26 rupees a day was enough to avoid poverty. In the uproar that followed, the Indian (and international) media noted that even the World Bank - not seen by most Indians as a benevolent institution - used a poverty line of $1.25, which, at the exchange rate of 53 rupees to the dollar, was more than twice as generous as the government’s line.

Reading

“Purchasing power parity is a disarmingly simple theory that holds that the nominal exchange rate between two currencies should be equal to the 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.” - p135

“many of the inputs into a tall latte or a Big Mac cannot be traded internationally or not easily at least: each good contains a high service component - the wages of the persona serving the food and drink - and a high property rental component - the cost of providing you with somewhere to sit and sip your coffee…” “Neither the service-sector labour nor the property is easily arbitraged internationally, and advocates of PPP have generally based their view largely on arguments relating to international good arbitrage.” -p136

“the presence of transaction costs - perhaps arising from transport costs, taxes, tariffs and duties and nontariff barriers” -p137

Summary

• the PPP exchange rate is the rate at which one country’s currency would need to be converted into another’s to buy the same basket of goods and services in each country

• in practice, PPP often does not hold, primarily due to various barriers to trade and migration and transaction costs.

• Deviations from PPP are not random: prices, especially those for services, tend to be higher in countries with higher per capita incomes