25.1 Purchasing power parity button

25.1 Purchasing power parity button

Courtesy of McDonald's Corporation;

The purchase power parity theory (PPP) says that exchange rates will adjust such that a given market basket of goods and services will cost the same in all countries. If the market basket costs $1,000 in the United States and 100,000 yen in Japan, then the exchange rate will be $1 = 100 yen (= 1000/100,000). If instead the exchange rate is $1 = 110 yen, we can expect the dollar to depreciate and the yen to appreciate such that the exchange rate moves to the purchasing power parity rate of $1=100 yen. Similarly, if the exchange rate is $1 = 90 yen, we can expect the dollar to appreciate and the yen to depreciate. For the past 14 years, The Economist magazine has offered a light-hearted test of the purchasing power parity theory through its Big Mac index. It uses the exchange rates of 100 countries to convert the domestic currency price of Big Macs into U. S. dollar prices. If the converted dollar price in, say, Britain exceeds the dollar price in the United States, The Economist concludes (with a wink) that the pound is overvalued relative to the dollar. On the other hand, if the adjusted dollar price of the Big Mac in Britain is less than the dollar price in the United States, then the pound is undervalued relative to the dollar. The Economist finds wide divergences in actual dollar prices across the globe and thus little support for the purchasing power parity theory. Yet it humorously trumpets any predictive success it can muster (or is that "mustard"?). Some readers find our Big Mac index hard to swallow. This year (1999), however, has been one to relish. When the Euro was launched at the start of the year most forecasters expected it to rise. The Big Mac index, however, suggested the euro was overvalued against the dollar—and indeed it has fallen [13 percent] … Our correspondence have once again been munching their way around the globe … [and] experience suggests that investors ignore burgernomics at their peril. (1) Maybe so—bad puns and all. Economist Robert Cumby examined the Big Mac index for 14 countries for ten years. (2) Among his findings: A 10 percent undervaluation according to the Big Mac standard in one year is associated with a 3.5 percent appreciation of that currency over the following year. When the U.S. dollar price of Big Macs is high in a country, the relative local currency price of Big Macs in that country generally declines during the following year. Hmm. Not bad. "Big MacCurrencies," The Economist, April 3, 1999; "Mcparity," The Economist, December 11, 1999. Robert Cumby, "Forecasting Exchange Rates and Relative Prices with the Hamburger Standard: Is What You Want What You Get with Mcparity?" National Bureau of Economic Research, January 1997.