Burgernomics: A more digestible way to understand exchange-rate theory

Burgernomics: A more digestible way to understand exchange-rate theory

The Big Mac Index was invented by The Economist in 1986 as a way of measuring currency under/over value. The idea is based on Purchasing Power Parity (PPP), in other words exchange rates should aim for a rate that equalises the price of the same product in two different countries. Burgernomics makes reference to the idea of the Big Mac PPP, which examines the purchasing power parity between nations, using the cost of a Big Mac as the benchmark.The Big Mac index was first published in 1986 as a tongue-in-cheek example of PPP across nations. Today the term burgernomics is commonly used by economists when referring to the Big Mac PPP.

One of the foundations of international  economics is the theory of purchasing   power parity (PPP), which states that price levels in any two countries should be identical after converting prices into a common currency. As a theoretical proposition, PPP has long served as the basis for theories of international price determination and the conditions under which international markets adjust to attain long-term equilibrium. As an empirical matter, however, PPP has been a more elusive concept.

Since 1986, The Economist has published an annual tongue-in-cheek  comparison of the prices of the McDonald’s Big Mac™ sandwich in various countries around the world, evaluating prevailing exchange rates on the basis of international price differences.

1 A similar index has also been developed by the financial firm UBS, as
part of a general comparison of prices and incomes around the globe.

2 These lighthearted studies of international hamburger prices have predictably been popular examples of the principles of PPP and have even given serious scholars food for thought.

3 The attractive feature of the Big Mac as an indicator of PPP is its uniform composition. With few exceptions, the component ingredients of the Big Mac are the same everywhere around the globe.

For that reason, the Big Mac serves as a convenient market basket of goods through which the purchasing power of different currencies can be compared.As with broader measures, however, the Big Mac standard often fails to meet the demanding tests of
PPP. In this article, we review the fundamental theory of PPP and describe some of the reasons why it might not be expected to hold as a practical matter.Throughout, we use the Big Mac data as an illustrative example. In the process, we also demonstrate the value of the Big Mac sandwich as a palatable measure of PPP.

Working for a Big Mac

Burgernomics_A_Big_Mac_Guide_to_Purchasing_Power_Parity

 

WHY DOES PPP FAIL?
In 2002 it cost $2.49 to buy a Big Mac in the United States, $3.80 in Switzerland, and $1.27 in China. Thus a Big Mac devotee could buy one and a half of the sandwiches in the United States for every one he could purchase in Switzerland. He could buy only one-half a Big Mac in the United States for every one he could enjoy in China.

One wouldn’t expect Swiss and U.S. consumers to import Big Macs from China to take advantage of the lower prices—a Big Mac sandwich shipped halfway across the globe would probably not arrive in a very appetizing form. Nevertheless, because the components of a Big Mac are traded on world markets, the law of one price suggests that prices of the components should be the same in all markets.

If the Big Mac is no more than the sum of its ingredients, then trade should equalize the price of a Big Mac across borders; or, at the least, differences between prices should narrow over time. Instead, the dollar price of a Big Mac in the three countries
diverged by even more in 2003 than in 2002. In 2003 it cost $1.20 to buy a Big Mac in China, $2.71 to buy a Big Mac in the United States, and $4.60 to buy a Big Mac in Switzerland.How do we explain these deviations from PPP?

Once again, the Big Mac can serve as a useful example of why there tend to be systematic departures from PPP. We consider three main explanations: the existence of barriers to trade, the inclusion of non-traded elements in the cost of a Big Mac, and pricing to market.

Although the theory of PPP serves as a useful benchmark for thinking about long-term equilibrium in foreign exchange markets, it generally does poorly as a predictive tool. A great deal of research effort has been put into tests of PPP and in constructing
price measures for consistent bundles of commodities across countries. It is interesting to find that the simple collection of items comprising the Big Mac sandwich does just as well (or just as poorly) at demonstrating the principles and pitfalls of PPP as do more sophisticated measures.This is perhaps not surprising when we consider that the Big Mac is a composite of tradable commodities and non-tradable service content. Its ingredients are subject to various tariffs and non-tariff trade barriers in countries around the world.

Finally,though it may have close rivals in some markets, the Big Mac itself is produced by only one company;hence we might expect to find elements of imperfect competition.That many of its basic ingredients are tradable goods would lead us to believe that Big Mac prices around the world should be driven to equality by arbitrage. Its other characteristics make the Big Mac a good example of why the theory of PPP generally fails to hold except under special circumstances. Even within the United States the price of a Big Mac varies across cities. The U.S. price of a Big Mac in The Economist survey is based on the average price in Atlanta, Chicago, New York, and San Francisco. Although The Economist does not publish data on individual U.S. cities, an example of the range of U.S. prices can be gleaned from the most recent UBS survey of prices and earnings. The survey covers four U.S. cities: Chicago, Miami, Los Angeles, and New York. The price of a Big Mac in 2003 ranged from $2.03 in Miami to $3.04 in New York. Although tariff barriers are nonexistent between Miami and New York, other factors that result in deviations from PPP across borders do exist—transportation costs and differences in sales taxes, prices of nontraded goods (wages, rents, and utilities), and competitive conditions.

Nevertheless, the $1.01 difference in high and low Big Mac prices across these U.S. cities is less than the range of differences for Big Mac prices across countries. A series of recent studies have shown that this observation holds across a range of goods.There is still much to be learned about the role of international borders in driving deviations from PPP

 

Burgernomics: A more digestible way to understand exchange-rate theory

Ref :

  1. https://research.stlouisfed.org/publications/review/03/11/pakko.pdf
  2. http://www.warren.lu/article/burgernomics-more-digestible-way-understand-exchange-rate-theory
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