Economist Writing Every Day

I’m advising a senior thesis for a student who is examining the strength of Purchasing Power Parity in hyper-inflationary countries. Beautifully, the results are consistent with another author* who uses a more sophisticated method.

For those who don’t know, absolute purchasing power parity (PPP) depends on arbitrage among traders to cause a unit of currency to have the same ability to acquire goods in two different countries. If after converting your currency you can afford more stuff in foreign country, then there is a profit opportunity to purchase there and even to re-sell it in your home country.

Essentially, when you make that decision, you are reducing demand for the good in your home country and increasing demand in the foreign country (re-selling affects the domestic supply too). Eventually, the changes in demand cause the prices to converge and the arbitrage opportunities disappear. At this point the two currencies are said to have purchasing power parity – it doesn’t matter where you purchase the good.

So does PPP hold? One way that economists measure the strength of PPP is by measuring the time that it takes for a typical purchasing power difference to be arbitraged away by 50% – its ‘half-life’.  The more time that is required, the less efficient the markets are said to be.

The ex-ante question is: Is PPP be stronger or weaker during hyperinflationary periods?

There are 2 competing hypotheses:

1. Hyperinflation contributes to price discoordination because it is associated with a volatile price level. We know that hyperinflation is associated with lower output. But maybe the price discoordination ‘bleeds’ into the international markets such that foreign exchange markets also can’t keep-up with the volatile prices. PPP is achieved more slowly.
2. Hyperinflation contributes to price flexibility. It is well known in the literature that exchange rates are more responsive and flexible than are price levels. Maybe hyperinflation improves price flexibility and PPP is achieved more quickly.

My students calculated half-lives before and during hyperinflation for Zaire (1990-1996) and Germany (1914-1923). In both cases, half-lives were shorter during the hyperinflationary period. Not by much, but shorter all the same.

The implication for hyperinflation is that, despite the domestic economic discoordination, international markets begin to price more effectively. This interpretation must come with a caveat.  Effectively pricing a currency is not the same as a country achieving the maximum sustainable output. Hyperinflation has devastating effects. But, people between countries are better able to recognize and resolve arbitrage opportunities.

* Zhou, Su. 1997. “Purchasing Power Parity in High-Inflation Countries: A Cointegration Analysis of Integrated Variables with Trend Breaks.” Southern Economic Journal 64 (2): 450–67. https://doi.org/10.2307/1060860.