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What
do the prices of a BigMac Hamburger around the world tell us about
exchange rates?
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According to
the theory of Absolute Purchasing Power Parity (PPP) , the prices
of the same basket of goods in two different countries when expressed in
the same currency should equalize. BigMac hamburgers are almost identical
around the world because of MacDonald's quality control and may be used
as a such basket. Let e denote the exchange rate of country X's currency
per US dollar. We must have
Price of BigMac in US
* e = Price of BigMac in country X.
Hence, the exchange rate implied by PPP is
e = Price of
BigMac in country X / price of BigMac in US.
A country X's currency is said to be overvaluation(+) or undervaluation(-)
by y%, where
valuation y =
(exchange rate implied by ppp - actual rate) / actual rate x 100 %
Country X's currency is said to be overvalued if the implied exchange rate
is greater than the market exchange rate (country X's currency per US dollar);
and PPP says country X's exchange rate should devalue (or depreciate). And
vice versa.
From the Economist 2000 issue,
we know that
the price of a BigMac in the Unitied States was 2.5100
US dollars,
the price of a BigMac in Hong Kong was 10.2000
Hong Kong dollars.
The theory of Purchasing Power Parity implies an exchange rate of 10.2000/
2.5100 = 4.06
Hong Kong dollars per US dollar. The exchange rate of HK dollar against
US dollar was 7.7900 around 2000.
Thus PPP says HK dollars is undervaluated by 48%.
(See the additional readings section for more information)
In the following table, you may give another Big
Mac price into the domestic price column and then click the button "Calc
me" to calculate the new implied PPP. As you can see, the price of Big
Mac and the implied PPP are positively related.
Additional
readings:
The exposition
of Purchasing Power Parity may be found in standard International Economics
or International Finance textbooks, e.g., Krugman and Obstfeld (1997).
Data of BigMac prices around the world is from various issues (usually
in April, starting from 1986) of The Economist. These issues of the Economist
also discuss the behavior of PPP implied exchange rates and its comparison
with the actual exchange rate.
REFERENCES:
Cumby,
Robert (1996): "Forecasting Exchange Rates and Relative Prices With the
Hamburger Standard: Is What You Want What You Get With McParity?" National
Bureau of Economic Research Paper: 5675, July 1996, pages 13.
Ong, Li-Lian
(1997): "Burgernomics: The Economics of the Big Mac Standard," Journal
of International Money and Finance; 16(6), December 1997, pages 865.
Click,
Reid W. (1996) "Contrarian MacParity," Economics Letters; 53(2), November
1996, pages 209-12.
Pakko,
Michael; Pollard, Patricia S. (1996) "For Here or To Go? Purchasing Power
Parity and the Big Mac," Federal Reserve Bank of St. Louis Review;
78(1), Jan.-Feb. 1996, pages 3-2.
Krugman,
Paul R.; Obstfeld, Maurice "International Economics : Theory and Policy,"
Fourth Edition Addison Wesley.
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