Home > Economics - General > The purchasing power parity hypothesis in Europe

The purchasing power parity hypothesis in Europe

October 28th, 2005

One of the big issues in the debate over the euro is whether Europe is an optimal currency area, that is, whether prices in Europe move sufficiently closely together to make a common monetary policy a reasonable idea. Looking at the issue when the move to the euro was agreed most observers would have said that Europe wasn’t an optimal currency area. A plausible counterargument is that monetary union will produce the kind of economic integration required. A quick scan of the web didn’t turn up much[1], so I thought I’d do a quick and rough check of my own, so I World Economic Outlook Database, which gives, among lots of other useful things, estimates of purchasing-power-parity adjusted exchange rates for all the countries in the data set. Since the calculations are based on the EU-centric international comparisons project, comparisons of relative price levels between EU countries should be pretty good.

So I looked at the log variance of the $US PPP exchange rate for the euro-12 countries from 1995 to 2005 and here’s what I got

200510281624

The log variance is a measure of the extent to which real price levels differ and, as the chart shows it has declined smoothly since the beginnings of the move to the euro.

Another interesting feature of the data is the average PPP exchange rate is around $US1.16 to the euro, very close to the rate that actually prevails.

fn1. I found one study by Robert Hill of UNSW, but it only went up to 2000 and covered the whole EU not just the eurozone. Hill found some convergence in price levels, but not as strong as this, but a surprising divergence in relative prices. It would be interesting to check on this.

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  1. Andrew Reynolds
    October 28th, 2005 at 18:59 | #1

    It would be interesting to repeat the analysis on the entire world – I remember seeing some analysis that discussed the entire planet as an optimal currency area and it would be instructive to see if this follows through. Could you post the tool you used to do the chart?

  2. jquiggin
    October 28th, 2005 at 21:55 | #2

    I just used Excel for this. I’ll try and get the data etc into some sort of shape and post it.

  3. October 28th, 2005 at 22:46 | #3

    In the mid to late 19th century, monetary union worked in the (then disparate) parts of Germany, but the competing Latin League of France, Italy and I think Switzerland was much less successful and ultimately failed (though you can’t rule out other causes too). But the economics of it may have been affected by the Gold Standard, the presence of rentiers and political clients, and who knows what else that is different now – possibly even materially different.

  4. Terje Petersen
    October 29th, 2005 at 12:27 | #4

    A lot of the early work on optimal currency areas was done by Robert Mundell. It is in fact what his Nobel prize in 1999 was predominantly for. Robert Mundell has indicated that in his view the optimal currency area is the globe. Which is in essence what we had prior to the 1970s.

  5. MB
    October 29th, 2005 at 17:17 | #5

    I’ve heard second- and third-hand stories from Italians and Greeks about how conversion has pushed up prices in those countries. This is a fairly big problem for countries like Italy and Greece, where the relative affordability of their currencies was a big plus for their tourist industries.

  6. Derick Cullen
    October 29th, 2005 at 17:53 | #6

    I am sadly disappointed that the Economist’s Big Mac Index PPP cannot shed light on PrQ’s question. Unfortunately the 5 June 05 release of the BMI shows a weighted average for the Euro area and not the underlying country data.

    However, in the write up of the BMI, there is a discussion of some of the advantages and disadvantages of PPP analysis which suggest there should not be a complete convergence. And it also raises another question: how much of the convergence observed by PrQ is down to Euro activity and how mich to pervasive globalisation influences?

    Some quotes from 9 June 05 Economist…

    “Economists lost some faith in PPP as a guide to exchange rates in the 1970s, after the world’s currencies abandoned their anchors to the dollar. By the end of the decade, exchange rates seemed to be drifting without chart or compass. Later studies showed that a currency’s purchasing power does assert itself over the long run. But it might take three to five years for a misaligned exchange rate to move even halfway back into line. ”

    “Trade barriers, transport costs and differences in taxes drive a wedge between prices in different countries.”

    “More important, the $5.05 charged for a Swiss Big Mac helps to pay for the retail space in which it is served, and for the labour that serves it. Neither of these two crucial ingredients can be easily traded across borders. David Parsley, of Vanderbilt University, and Shang-Jin Wei, of the International Monetary Fund, estimate that non-traded inputs, such as labour, rent and electricity, account for between 55% and 64% of the price of a Big Mac*.
    The two economists disassemble the Big Mac into its separate ingredients. They find that the parts of the burger that are traded internationally converge towards purchasing-power parity quite quickly. Any disparity in onion prices will be halved in less than nine months, for example. But the non-traded bits converge much more slowly: a wage gap between countries has a “half-lifeâ€? of almost 29 months.”

  7. Patrick
    October 29th, 2005 at 19:26 | #7

    MB, it certainly did push up prices in France – 10FF became 2€ overnight – but 2€ = 13.3FF. Not necessarily deliberate, and other factors have raised prices, but popular resentment of the Euro is higher than you hear.

  8. F
    October 29th, 2005 at 20:36 | #8

    John: yours is indeed a beautiful idea.

    About 30 years ago, I used Hans Genberg’s work on PPP during the Bretton Woods era. My tack was to find out what happens to relative (cross country) price dispersion within the currency area when the dispersion of the aggregate price level changes. It was a positive relation. Prices must diverge (from PPP) when turbulence increases, and vice versa. Only to show that it works in the long run, as Philip Jorion and Niso Abuaf showed it then.

    And yes, I can report from Portugal that prices have certainly rocketed after the introduction of the euro. And have not stopped yet. Particularly, the non tradeables: the morning coffee, the haircut, the market vegetables.

    Thanks.

  9. Terje Petersen
    October 30th, 2005 at 13:45 | #9

    Here is the talk by Robert Mundell that I was looking for.

    http://www.columbia.edu/~ram15/eOCATAviv4.html

    Robert Mundell won his nobel prize for:-

    ” his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.”

  10. Manfred Klamer
    November 5th, 2005 at 01:56 | #10

    Hello,
    could anyone help me out? I am business student to write my diploma about the Big Mac Index in the light of purchasing power parity.
    Does anyone know where I can find the Big Mac prices of the last decade(s) in an excel-working format?
    I already contacted “The Economist” but they could not help me out.
    So, thank you for any help.
    Manfred Klamer
    Germany

  11. jquiggin
    November 5th, 2005 at 08:30 | #11

    Hi Manfred,

    Your best bet would probably be to get the data from back issues of the Economist. It’s not the kind of thing that’s going to be available from a public source, given that the Economist itself doesn’t compile it.

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