The traditional theory - [the law of one price for traded goods] -- works best for pairs of countries that trade a lot with each other, and who share a relatively stable real exchange rate.
Since the 1990s, a debate has raged over the relationship between currency depreciations and the prices of domestic goods. Traditionalists argue that when a nation's nominal exchange rate rises, the prices of its traded goods rise, so that the real exchange rate of traded goods between two countries remains roughly the same. Contemporary U.S. exchange rate and price behavior, however, casts doubt on this view, and an alternative has emerged which suggests that currency depreciations have little or no effect on domestic prices. This alternative view, known as the New Open Economy Macroeconomics (NOEM), implies that when a country's currency depreciates its goods simply become less expensive compared with those of other countries.
In Real Exchange Rate Movements and the Relative Price of Non-Traded Goods (NBER Working Paper No. 14437), Caroline Betts and Timothy Kehoe examine recent price and exchange rate movements to help distinguish between these two views. They study the quarterly bilateral real exchange rate and the relative price of non-traded to traded goods for 1225 country pairs over 1980-2005. They show that there is a strong relation, on average, between depreciations and domestic prices, especially between two countries that trade intensively with each other. The exception, which conforms more closely to the emerging "alternative" view, is trade between North America and the European Union.
Their findings suggest that "neither the extreme approach to bilateral real exchange rate determination of the traditional theory nor that of the NOEM literature is appropriate The traditional theory works best for pairs of countries that trade a lot with each other, and who share a relatively stable real exchange rate. The NOEM approach applies best to pairs of countries that trade little and share a relatively volatile real exchange rate."
This debate is important because of what it says about the so-called "law of one price," which holds that traded goods have one price no matter where they are sold. So an exportable good - a Japanese tire or an American car - would cost the same whether it was sold domestically or abroad, after transportation and other costs are factored in. If one nation's currency depreciates, then its traded goods would become cheaper for foreign consumers, who would begin to snap them up until the prices of those goods began to rise. Eventually, prices will return to the point where the real price of that nation's goods, measured in either the home country's prices or those of its trading partner, would again equal the prices of goods produced by its trading partner in either market.
The law of one price doesn't hold for non-traded goods, like a haircut, because such goods cannot be moved across markets. Thus, currency depreciation could cause the ratio of the price of a nation's non-traded goods to that of its traded goods to rise. For example, it would take more haircuts to equal the market price of a car.
Historically, economists have noticed that the law of one price doesn't always hold for traded goods. In many cases, especially in trade between the United States and the European Union, depreciations seem to have no price impact at all. Such findings led to the NOEM school of thought, which suggests that monetary policy could explain most or all of the fluctuations in nations' real exchange rates of traded goods.
In the Betts and Kehoe study, which examines bilateral trade among 50 countries, the law of one price does not hold for traded goods, but it comes closer than for non-traded goods. Put another way, currency movements affect the ratio of the prices of a nation's traded and non-traded goods. The effect is especially strong if two countries trade intensively. This relationship holds even when there are wide disparities in wealth or inflation between the two nations.
When the authors include China, for which the data is annual rather than quarterly and only dates back to 1985, the results change very little. But for the United States and its European trading partners, the relationship is dramatically weaker. Fluctuations in the relative price of non-traded-to-traded-goods account for only 7 percent of the fluctuations in the bilateral U.S./EU real exchange rates when measured in four-year differences using a variance decomposition. By contrast, these relative price fluctuations account for 29 percent of the fluctuations in U.S./non-EU real exchange rates and 39 percent of the fluctuations in U.S./Canada and U.S./Mexico real exchange rates. The authors suggest that the lower ratio for the United States and the EU nations may be attributable to the relatively low importance of trade, compared to the size of these economies. They note that just because there's a relationship between exchange rates and domestic prices, it does not follow that one drives the other.
-- Laurent Belsie