Purchasing Power Parity with Strategic Markets

In: The B.E. journal of theoretical economics, Band 8, Heft 1

Abstract

The paper shows that market power may be an additional cause for the failure of PPP without making the usual assumption of segmentation of national markets. We construct an international multi-currency economy based on the strategic market game model with multiple trading posts, where, besides sellers, buyers have market power as well. Although arbitrage is costless, PPP may fail and exchange rates may be inconsistent at equilibrium due to agents' price effects in currency and commodity markets. We derive conditions on individual net trades and elasticities that result in PPP violation and exchange rate inconsistencies. A numerical example shows that when consistency fails, the ordering of prices is not well-defined. When the number of agents in the economy increases, PPP deviations and inconsistencies tend to zero, thus providing a strategic foundation of PPP theory. Furthermore, the size of PPP deviations is positively related to the number of currencies traded.