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Document Analysis and Data Processing

This document discusses the purchasing power parity (PPP) theory and how the Big Mac index can help evaluate it. PPP states that price levels in countries should be the same when converted to a common currency, but prices often differ due to exchange rate fluctuations. The Big Mac index, published annually, compares the price of a Big Mac in different countries and uses it as a "basket of goods" to gauge if currencies are over or undervalued relative to the US dollar based on international price differentials. For example, in 2010 the Big Mac was most expensive in Norway, indicating the Norwegian krone was overvalued by nearly 100% against the dollar. The index helps identify when exchange rates need to adjust to reach PPP

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Paramjit Singh
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12 views2 pages

Document Analysis and Data Processing

This document discusses the purchasing power parity (PPP) theory and how the Big Mac index can help evaluate it. PPP states that price levels in countries should be the same when converted to a common currency, but prices often differ due to exchange rate fluctuations. The Big Mac index, published annually, compares the price of a Big Mac in different countries and uses it as a "basket of goods" to gauge if currencies are over or undervalued relative to the US dollar based on international price differentials. For example, in 2010 the Big Mac was most expensive in Norway, indicating the Norwegian krone was overvalued by nearly 100% against the dollar. The index helps identify when exchange rates need to adjust to reach PPP

Uploaded by

Paramjit Singh
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd

c

For historical and political reasons every country (and now some regions like the
European Union) have their own currency. Comparison between currencies is
important for international trade as it helps determine fair price for goods and
services traded across international borders. This comparison is called the exchange
rate (FX).

If we were travelling in a foreign county and walked into a coffee shop to find the
price of a five-dollar cup of coffee to be $100, converted to American dollars. What
would this indicate to us? Discounting that the coffee is not some exotic and very
special and that the business is not a swindle, this would clearly indicate that the
currency of the country is grossly overvalued. In other words, too many dollars are
required to buy too small a quantity of that currency. Taking this analogy further if
this country reports an economy size of a hundred million and an economic growth
of 10% it would be easy to understand that the economy is actually equivalent to 5
million and the growth is adding only 0.5 million each year.

This helps understand the purchasing power parity (PPP) theory, which states that
price levels in any two countries should be the same on conversion to a common
currency to enable proper comparison. But price of what? Theory conventionally
looks to compare the price of a µbasket of goods¶, which represents average consumer
spending. This basket may be hundreds of items as used in the Penn World Tables,
or something as simple as McDonald¶s Big Mac. j 
publishes an annual
comparison of what it costs to buy a Big Mac in different countries, thus helping
evaluate prevailing FX rates based on international price differentials. The Big Mac
index is not as simple or light hearted as appears at first sight as it r epresents a
standard mix of ingredients (Click, 1996) or a good µbasket of goods¶. Based

Click, R. W. (1996). Contrarian MacParity.   

 , Vol. 53(2), pp. 209-12.

Based on the July 22, 2010 prices published by j 


, a Big Mac costs $3.73
in the US. The same Big Mac costs the equivalent of $4.o7 in Australia, $1.95 in
China, $4.37 in the Euro area, $2.31 in Russia, and $2.66 in Saudi Arabia. This
indicates that the current exchange rate between the USD and the AUD (1.06 at that
time) shows an overvaluation of the latter by 9.61% i.e. the AUD must come down by
9.61% to reach PPP. On the other hand, the Chinese Yuan is undervalued by 47.60%
meaning that the exchange rate of Yuan must increase (fewer Yuan for every dolla r)
to reach PPP.
The Big Mac theory (and PPP) suggests that if the price of a Big Mac is ¼3.38 in the
EU and $3.73 in the US then the exchange rate ought to be 3.38/3.73 or 0.91.
However, the actual rate fetches 0.766 Euros for every Dollar. This means that the
Euro is overvalued by (0.91-0.766)/0.766 or 18.8% and the exchange rate must come
down over time until it reaches PPP.

The latest Big Mac index indicates that the Big Mac is the most expensive in Norway
where it costs the equivalent of $7.3844 indicating an overvaluation of the Kroner by
nearly 100% (98.55) and that this must come down.
Where the demand-supply equation changes determine FX rates the rate is called the
floating rate, and the rate changes constantly based on trade balance movement and
market sentiment. Conversely, some countries (notably China) fix their exchange
rates through government regulation, sometimes called the µmanaged¶ exchange rate.
In addition, several other factors influence FX rates. These are:

Ôc Interest rates

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