Measurement matters: Productivity-adjusted weighted average relative price indices

• Published in: Journal of international money and finance Vol. 61; pp. 45 - 81
• Main Author: Campbell, Douglas L.
• Format: Journal Article
• Language: English
• Published: Kidlington Elsevier Ltd 01.03.2016; Elsevier Science Ltd
• Subjects: Balance of trade; Balassa–Samuelson; Developing countries; Economic crisis; Employment; LDCs; Manufacturing; Predictions; Price indexes; Productivity; Real exchange rate indices; Relative unit labor cost indices; Studies; Trading partner substitution bias; United States; Weighted average relative prices; United States > US; Balassa–Samuelson; Trading partner substitution bias; F10, F31, N70, C43; Weighted average relative prices; Real exchange rate indices; Relative unit labor cost indices
• ISSN: 0261-5606; 1873-0639
• DOI: 10.1016/j.jimonfin.2015.10.002

•I have produced Weighted Average Relative Price (WARP) indices for 154 countries for the period 1950–2011 using the last three versions of the Penn World Tables.•I have produced an historical WARP index for the US, from 1820 to 2011.•I find that in the early 2000s, during the collapse in US manufacturing, the US price level had not been that high relative to trading partners since the worst year of the Great Depression.•I propose a productivity adjustment to WARP to adjust for the observed “Penn Effect”, and also produce Penn Effect-adjusted WARP indices for 154 countries over the period 1950–2011.•I propose a new Weighted Average Relative Unit Labor Cost index (WARULC) which solves index numbers problem in the IMF's index.•For the US, I show that WAR indices seem to do a better job predicting trade flows and declines in manufacturing employment than do previous RER indices. Commonly used trade-weighted real exchange rate indices are computed as indices-of-indices, and thus do not adequately account for growth in trade with developing countries. Weighted Average Relative Price (WARP) indices solve this problem but do not control for productivity differences, as developing countries are observed to have lower price levels via the Penn Effect. I remedy these problems in two ways. First I propose a Penn Effect productivity adjustment to Weighted Average Relative Price indices (P-WARP). Secondly, I introduce a Weighted Average Relative Unit Labor Cost index (WARULC) for manufacturing and show that this measure does a much better job predicting trade imbalances and declines in manufacturing employment than the IMF's Relative ULC measure created as an index-of-indices. The new series reveal that for many countries currently mired in liquidity traps, relative prices reached historic highs heading into the financial crisis of 2008. I document that in 2002 – during the surprisingly sudden collapse in US manufacturing – US relative prices had not been that overvalued relative to trading partners since the worst year of the Great Depression.