By ALVIN H. HANSEN
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Extra resources for Monetary Theory and Fiscal Policy
Even supposing the air ticket was free would you really fly 8 hours for a cheaper haircut? The PPP concept assumes there are no barriers to the arbitraging of price differentials, yet with non-tradable goods this may not be the case. Granted, there may always be some wayward individuals who would actually take that flight! PPP or the law of one price holds better of necessity for homogeneous commodities that are traded internationally, with arbitrage opportunities being quickly eliminated. However, even here, care is needed.
In addition, I enclose a model focusing on the “speculative cycle”, which takes place in freely floating exchange rate regimes. Here, I make no claim to a definitive breakthrough. However, I do feel these two models capture the essential dynamics of the currency crisis on the one hand and the currency cycle on the other. The emphasis in this chapter is on the emerging markets for the most part, largely because ever since the 1992–1993 ERM crises the developed markets have no longer presented such easy targets.
However, a higher domestic cost base means of necessity that a manufacturer of whatever nationality either deliberately undercuts the domestic price structure, thus making a loss, or keeps export prices lower than domestic ones. The higher cost base and consumer price tolerance work hand in hand. In the US, because US consumers are used to a system, which exemplifies a very high level of competition, this drives down retail prices, reducing consumer “price tolerance”. PPP theory states that the exchange rate should adjust for price differentials in the same good.