One implication of this is that in a world where PPP holds, the law of one price means that the exchange rate appreciation/depreciation will reflect the countries’ differential inflation. So, if the yuan depreciates at a 10% rate and the US inflation rate is 2%, it follows that the prevailing Chinese inflation will be 12%. That was roughly the situation in China prior to 1994. The currency depreciation reflected the inflation rate differential. But then, in 1994, China pegged its currency to the US dollar and, lo and behold, Chinese inflation converged to that of the United States (Fig. 45.1) just as the PPP theory suggests. Notice the convergence of the inflation rates once the Chinese pegged to the US dollar.

Fixing the exchange rate was a brilliant move. It solved the inflation problem and introduced some transparency into the Chinese economy and, to a large extent, it enhanced property rights. As long as the peg was maintained, the Chinese people knew what the purchasing power of their currency would be. In fact, they knew more than that. They knew that the target decline in their purchasing power would be around 2%, the Fed’s inflation rate. Outsourcing its monetary policy to the Fed was a stroke of genius.

All of this suggests that while haircuts are available in every country, the prices may differ across countries. More importantly, transportation costs may prevent consumers from arbitraging the differences in price. As we already mentioned, under these conditions, the price of the haircut will be determined by local demand and supply conditions. In contrast, the fully traded commodities that face little or no transportation costs have prices that are determined in the global economy by global demand and supply conditions.

The range of transportation costs suggests that there are varying degrees of price integration across national economies. For the fully integrated commodities, the prices will move in unison, while for the nontraded commodities, the prices may be totally uncorrelated and dependent on local demand and supply conditions. The concept of PPP is the idea behind the Big Mac standard, popularized by The Economist. It converts the price in local currency to a dollar price to measure the deviations from PPP across national borders. Hence the closer the dollar prices, the greater the degree of integration, and vice versa.

Armed with these insights, we can now derive some implications regarding different relative prices across different localities. To begin, during the period in question China’s exchange rate was mostly fixed to the US dollar, the PPP framework suggests that the traded goods’ inflation rate would be determined by the Fed and the underlying traded goods’ inflation should be the same for both countries at all times during the period.

The nontraded goods story is a bit different. Take for example, the episode during the global financial meltdown. At the time, the United States experienced a deep recession, while China’s market continued its high and positive rate of growth. Based on the change in relative economic performance between the United States and China, we can argue that relative to the traded commodities, the price of nontraded goods and services declined in the United States, while at the same time the price for the nontraded relative to traded commodities rose in China.

The rate of change of the price of the traded goods will be somewhere in between the inflation rate of the two’s (i.e., China and the United States) nontraded goods. That alone suggests that China should have experienced a higher “measured” inflation than the United States. Fig. 45.1 suggests that was the case. Notice that China’s inflation rate steadily rose relative to the United States since the beginning of the millennium, and was higher than the US inflation rate in the aftermath of the US recession.

The differences in inflation rates are attributable to the change in nontraded goods (e.g., housing prices, haircuts, and other services) across the region and their relative weight in the national consumer price index (CPIs). As each national CPI has a domestic component of “nontraded” goods, the ratio of the two countries’ CPIs (in a common currency, i.e., the US dollar) captures the changes in the nontraded goods’ relative price across national borders. So, we can use the ratio of the two as a proxy for the traded versus nontraded goods arguments.

If we are right, we should see the CPI in the US decline relative to the Chinese CPI, measured in dollars, during recession periods when the housing market and other nontraded goods declined in the United States relative to the price of nontraded goods in China. The data reported in Fig. 45.1 is consistent with this interpretation. More importantly, the decline in nontraded goods will have a larger downward pressure on the CPI in the United States than the nontraded good prices in China will have on the Chinese CPI.

The two distinct effects suggest that investors and policymakers have a signal extraction problem. When they see exchange rate fluctuations, they will have to determine whether the exchange rate reflects a differential inflation rate, as the PPP framework suggests, or real return differentials across national boundaries, as the terms of trade effect suggests.

Fortunately, The Economist’s Big Mac standard provides us with an answer. If the exchange rate reflects an inflation differential, that is, a PPP world, the dollar price of the Big Mac in the foreign economy will be the same or move in unison with the price of the Big Mac in dollars. If there are changes in the dollar price of the Chinese Big Mac relative to the United States, then Big Mac prices would reflect a terms of trade change, that is, a change in relative rates of return. Generalizing the Big Mac standard to the overall price level, we get a measure of terms of trade between two economies. The results of such calculations are reported in Fig. 45.2. The data presented suggests a secular upward trend from the 1980s to the millennium. Obviously, there are some cyclical fluctuations around the secular trend, which also suggests that there were some hiccups along the way. Fig. 45.2 also points to a steady deterioration of the US terms of trade vis-a-vis China that began around 2005 and lasted until 2014. It is interesting and ironic, as that is when the pressure began to mount to designate China a currency manipulator. The irony is that during this time period the Chinese maintained a fixed exchange rate period. How could they haven manipulating the currency to gain a competitive advantage? The only way that would make sense if one had evidence that the exchange rate would have appreciated had it been free and reflected the terms of trade. However, as the data show, during that time the US–China terms of trade were deteriorating. That is, a unit of a Chinese goods was able to acquire a larger quantity of US goods. Even with a fixed exchange rate, the US–China terms of trade were adjusting and the adjustment was contrary to what the procurrency manipulators suggested. The US goods were becoming increasingly cheaper to the Chinese. Yet in spite of all this, every year US legislators have proposed some version of a currency manipulation bill. Fortunately, they have yet to be successful.

Nevertheless, there is legislation in place that allows the United States to pursue such actions. The process is a bit complicated. The US Treasury Department, in consultation with the International Monetary Fund (IMF) have to analyze the exchange rate policies of foreign countries on an annual basis. Treasury must decide by April 15 and October 15 whether to label countries like China a currency manipulator in its biannual report to Congress on the currency policies of its trading partners. The reports examine whether countries are manipulating their currency’s exchange rate with the US dollar “for purposes of preventing effective balance of payments adjustments or gaining unfair competitive advantage in international trade.” Such a designation would not necessarily result in the imposition of any penalties. Currently, the administration has discretion on how to respond to countries seen to be engaging in currency manipulation. However, if manipulation is found, the Treasury Secretary shall “initiate negotiations with such foreign countries on an expedited basis, in the IMF or bilaterally, for the purpose of ensuring that such countries regularly and promptly adjust the rate of exchange between their currencies and the United States dollar.” The Secretary of the Treasury “shall not be required to initiate negotiations in cases where such negotiations would have a serious detrimental impact on vital national economic and security interests.” In such cases, the secretary must notify leaders of the Senate Banking Committee and the House of Representatives’ Financial Services Committee of his decision. Although the legislators have tried almost every year to modify the existing legislation, the modifications legislation has failed to reach the president’s desk. During that time, the executive branch has chosen not to designate China a currency manipulator.

The slower growing country will experience a below trend increase in the inflation rate. The differential inflation rate then reflects the terms of trade changes. Applying the Big Mac standard, we expect the dollar price of China’s consumer basket, that is, CPI, to rise relative to the US basket. Fig. 45.2 shows that how many units of the Chinese consumer basket that one unit of the US consumer basket bought over the years. The data show that the US terms of trade steadily improved and peaked around the 1990s. As then the trend has been a downward one. This means that one unit of a Chinese nontraded goods steadily bought an increasing larger amount of the traded goods relative to the US counterparts. Fig. 45.3 plots the terms of trade and nominal exchange rates. A close inspection of the two series shows the close parallel between the two as the fixed exchange rate period. Prior to that, the nominal exchange rate rose much faster than the terms of trade, which we attribute to the higher inflation rate differential between the two countries. Since 1995, Chinese monetary policy during the fixed exchange rate period induced a convergence to the US inflation rate and, to the credit of the Chinese central bank, they have maintained the low-inflation rate policy (see Fig. 45.1).

The terms of trade adjustment are not unique to China and the dollar adjusted CPI ratio is not the only way to measure it. Take the case of the euro. Member countries also have a fixed exchange rate system. Hence, terms of trade changes cannot be accommodated by changes in the exchange rate. The terms of trade effects have to be accommodated by changes in domestic prices and/or production costs. This may be reflected in many different ways. For example, since the inception of the euro, up to 2015, unit labor costs in Germany have increased by single digits, somewhere around 6%. Yet during the same time, Greece’s unit labor costs have risen by more than 40%. This means that during that time, Germany’s competitive position has improved by 34%. Had the euro not existed, the mark would have appreciated 34% against the drachma. Put another way, with the same nominal production costs, German producers will have much higher profits and/or rate of return than Greek producers.

This example illustrates a simple point: markets have enough flexibility to accommodate relative price changes. Which prices change to accommodate or affect the relative price changes depends on the organization of the monetary system. Under a floating exchange rate combined with a domestic price rule, the exchange rate will reflect the relative price changes. Under a fixed exchange rate, domestic prices and unit labor costs have to change to reflect the relative price or terms of trade change.

Those politicians who argue that the Chinese or any other currencies fixed to the dollar are manipulating their currency to gain an unfair advantage are wrong. China’s currency is not overvalued by some 27%, as the protectionists say. The domestic prices and unit labor costs have already accounted for the terms of trade effect and, in doing so, they restored and maintain the true market-driven relative price, not an artificial one, as the critics of the then-China fixed exchange rate argued. At the time we argued that it was possible that China’s exchange rate would rise if its currency was floated, but we also argued that would be a reflection of a good monetary policy. Judging from the Chinese inflation, the answer must be that prior to the Chinese slowdown, the central bank did a pretty good job. We will discuss this topic further in a later chapter.