One important aspect of Purchasing Power Parity (PPP) doctrine is its espousal of law of one price, i.e. assuming one-way transport costs and tariffs. A HMT watch will be priced the same whether it is sold either in Mumbai or New York. But in the literature of international finance two stylized facts are prominently mentioned. First, real exchange rate movements are seen to be very persistent at the aggregate level of the economy. Second, individual prices of traded commodities tend to be sticky in terms of local currency at the micro level. Engel (1993) has compared the relative prices of different commodities within the same country versus relative price of the same commodity across different countries and he has reached the conclusion that the former measure is less variable in all but a few cases such as primary commodities and energy. Also Engel finds that the second relative price tends to be more volatile in nature and this proves that local prices in a given market remain comparatively stable.
The open economy models of the Keynesian tradition incorporate price stickiness and thus explain the overshooting of the exchange rate (Dorbush, 1976). But Keynesians often do not discuss the price stickiness at the buyer’s end that is in the currency of the destination, though price stickiness at sellers’ end is discussed. The law of one price coming from the standard PPP theory cannot explain the degree of persistence that is observed in real exchange rate series. It is seen that real and nominal exchange rates move together both in the short and in the long run.
The law of one price derived from PPP is used to explain the spatial arbitrage, as net of tariffs and transport cost. The price of a traded commodity should be the same bought anywhere in the world. On this Krugman (1989) writes:
[W]e must now admit that international Keynesianism, while more like reality than International monetarism, itself turns out to have a problem. It is not so far enough in rejecting international arbitrage. Not only does the Law of One Price fail to hold at the level of aggregate national price indices … it does not even hold at the level of individual goods (p. 43).
The law of one price has been subject to modifications and one such is pricing to market (PTM). The latter allows corresponding prices to diverge across markets favouring market segmentations and thus it negates spatial arbitrage. Thus across the countries economic barriers and structural rigidities persists which makes law of one price non-functional. Thus when the US dollar had been appreciating in the early 1980s, Dornbusch (1987) observes: export prices change little relative to domestic prices, even though there is no clear pattern of decline in all industries. By contrast, most import prices decline in terms of domestic goods. But the order of magnitude of the decline (in import prices) remains relatively small compared to the change in relative unit labour cost. With a change in unit labour costs of more than 40 per cent, the decline in the relative price is in most cases less than 20 per cent. This is not at all out of line with the theory once some degree of “pricing to the American market” is taken into account … (p. 104).
When the dollar depreciated during the period 1985-87, the import prices of Japanese manufactures in USA market did not rise proportionately.
When we allow the producers to price discriminate between local and foreign markets in the framework of the monetary model, it is possible to examine exchange rate pass-through and price to market behaviour under the assumptions of markets segmentation and relative price dynamics under nominal rigidities. In this framework the structure of trade can be incorporated and then it becomes possible to examine the cross-sectional implications of inter-sectoral versus intra-industry trade for macroeconomic adjustment.
‘The country generally follows a specific pattern of industrialization. This pattern of industry specialization and trade determines the degree of strategic complementarity or price linkages between producers from different countries. In the context of intra-industry trade there exists a high degree of linkage between home and foreign good prices prevailing in the same market as home and foreign products become close substitutes. This linkage is not so strong under inter-industry trade. The result is that domestic and export prices show greater responsiveness to the fluctuations of exchange rates. Further, this induces a lower degree of passthrough, as a greater degree of pricing to market under two-way trade.
When integration in the world market for commodities is not perfect, countries differ in their national consumption pattern and in the units of accounts in which prices are set. This is done to favour their own goods and own currency. But the law of one price holds and this ultimately equates currency adjusted prices across the different markets (Krugman, 1989). Under imperfect integration a greater degree of price linkages across countries translates into stronger mean reversion in the real exchange rate. The explanation is as follows: When production costs and prices move in a zigzag fashion, prices of commodities show intertia in terms of national currency unit as the economic agents work without any coordination. When the economy is open producers (exporters) are to consider both domestic and foreign market prices. The latter being less flexible, the producers are to see that domestic prices remain flexible. Thus prices become less rigid in terms of national currency so that variation in term of foreign currency is reduced. Thus strong international linkage under two-way trade reduces the variability and persistence of real exchange rate fluctuation compared to intersectoral trade.
This remains true as long as the assumption of spatial arbitrage holds. Once this is gone, the former conclusion no longer remains tenable. As obstacles are created both in the form of quantity restrictions or tariff barriers, price discriminations persist and variability of real exchange rate increases.
According to Faruquee (1995) pricing to market ensures greater price stability in terms of local currency than the alternative pricing system when especially exchange rate pass-through is more or less complete. Compared to the law of one price, market segmentation allows greater inertia in the domestic price level, but international relative prices adjust slowly. This way pricing to market (PTM) provides an important propagation mechanism for the explanation of large and protacted swings in the real exchange rates which have been a common phenomenon in the post-Brettonwoods period. This has monetary shocks have enduring effects on relative prices, and this induces nominal and real exchange rates move together in the short run, and these two move together in the longer run as well, when monetary shocks have permanent effects.