Purchasing Power parity & The Big Mac Index

Abstract
This paper looks into the issue of purchasing power parity (PPP) and the debate surrounding its existence in the short run. It includes a brief discussion on the implications of PPP in the macroeconomic and consumer level. Special focus is placed on the relationship between wages and real exchange rates across countries. The paper attempts to discover the extent to which shortterm departures from PPP can be attributed to wages. Conclusions are drawn from the results of two analysis methods using the Big Mac Index and the ILO October Inquiry as data sources.

What is Purchasing Power Parity (PPP)?

Purchasing power parity (PPP) states that the price of a good in one country is equal to its price in another country after adjusting for the exchange rate between the two countries. What all this consumer anxiety illustrates is that individuals, at an instinctual level, subscribe to the economic theory of Purchasing Power Parity (PPP). PPP states that price levels in any two countries should be identical after converting prices into a common currency and after accounting for transportation costs, taxes, and tariffs. A major foundation of PPP is the law of one price. It states that any good that is traded on world markets will sell for the same price in every country engaged in trade, when prices are expressed in a common currency. The reason for this is the possibility of international goods arbitrage, which allows an Individual to make a risk-less profit by taking advantage of price differentials (i.e., buying a product from a low priced country and selling the same product at the high priced country). These individual activities magnified at the macro, international level will cause the supply adjustments that will lead to the convergence of prices around the world. This is the main premise of the PPP theory. The method of measurements used affects important matters such as the global rate of growth and the extent of inequality between rich and poor countries. It also makes the appropriate ranking of countries in terms of the relative size of economies more ambiguous. Take China for example. Using simple market exchange rate conversions, its economy can be ranked as the 7 largest in the world. However, after adjusting for PPP, Chinas ranking moves up to the 2 largest in the world, just behind the United States (The Economist 2004b). This illustrates that currencies can be grossly over-valued or under-valued at a given point in time. Therefore, the use of market exchange rates alone can produce misleading results that stimulate bad policies.

A Bigmac PPP: As a light-hearted annual test of PPP, The Economist has tracked the
price of McDonald's Big Mac burger in many countries since 1986. This experiment - known as the Big Mac PPP - and similar tests have been underway for decades. Here we take a look at this unique indicator, and find out what the price of the ubiquitous Big Mac in a given country can tell us about its wealth.

What is Big Mac Index?

The Big Mac Index is an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries. It "seeks to make exchange-rate theory a bit more digestible.

Overview:The Big Mac Index Starting in 1986, the Big Mac Index (BMI) has been generated on an annual basis in order to evaluate the purchasing power parity of various currencies around the world. Although it is a simplification of the complex issues surrounding the international monetary system, it can serve as a proxy for the consumer price index (CPI) because the Big Mac is served in 120 countries around the world and, for the most part, uses the same ingredients in its composition. Therefore, it can be regarded as a small basket of goods that are comparable across many countries. A study conducted by David Parsley and Shang-Jin Wei showed that the Big Mac real exchange rates are highly correlated with the CPI-based real exchange rates both in levels and in first differences (2003). So the lessons from the Big Macs have general implications for CPIbased real exchange rates. The Big Mac Index has been derived from publications of The Economist magazine. The dataset includes Big Mac prices in the local currency and its corresponding price in US dollars based on the prevailing exchange rate at the time of publication. The US dollar was used as the nominal base currency2. As of 2004, The Economist has included up to 42 countries in the Big Mac Index. However, many countries have only been recently added and do not have complete historical data. For example, coverage for some countries started at later years like 1994 for Poland, 1996 for South Africa, 2001 for the Philippines, and 2002 for Turkey. Meanwhile, Big Mac Index data for countries like Ireland, Portugal, and Israel becomes unavailable starting on 1994, 1995, and 2001 respectively. Of most significant impact to the data source is the integration of the currencies of several European countries in 1999. When the physical currency became available in January of 2002, prices for Big Macs throughout the euro area were posted in euros and The Economist ceased from reporting prices of Big Macs for individual euro area countries. The inconsistency and data lapses in BMI information means only a subset of the entire time period covered is reliable enough to include in the dataset. For the purpose of this analysis, the time period from 1992 to 2001 will be used in order to have a complete series of contiguous data available for at least a 10-year period. Fourteen countries out of the 42 covered as of 2004 are able to meet this criterion. Using the reported Big Mac prices during this period and the prevailing monetary exchange rates for each corresponding year, real exchange rates can be calculated using the following formula: Price in foreign currency 1 ----------------------------------------- X --------------------------Price in US$ Exchange Rate Multiplying the result by 100, this calculation yields a BMI PPP valuation for each country where 100 equates to parity. Values below 100 indicate that the local currency is undervalued relative to the US dollar and values above 100 indicate that the local currency is overvalued relative to the US dollar. Table 1 displays the mean, minimum, and maximum values for each of the 14 qualifying countries.

Relation between Big Mac and PPP: (Hamburger Economics: The Big Mac Index)
To illustrate PPP, let's assume the U.S. dollar/Mexican peso exchange rate is 1/15 pesos. If the price of a Big Mac in the U.S. is $3, the price of a Big Mac in Mexico would be 45 pesos assuming the countries have purchasing power parity. If, however, the price of a Big Mac in Mexico is 60 pesos, Mexican fast-food shop owners could buy Big Macs in the U.S. for $3, at a cost of 45 pesos, and sell each in Mexico for 60 pesos, making a 15-peso risk-free gain. (Although this is unlikely with hamburgers specifically, the concept applies to other goods as well.) To exploit this arbitrage, the demand for U.S. Big Macs would drive the U.S. Big Mac price up to $4, at which point the Mexican fast-food shop owners would have no risk-free gain. This is because it would cost them 60 pesos to buy U.S. Big Macs, which is the same price as in Mexico thus restoring PPP. PPP also means there will be parity among prices for the same good in all countries (the law of one price). (To learn more about capitalizing on the relationship between price and liquidity.

Currency Value:In the example above, where the Big Mac is at a price of $3 and 60 pesos, a PPP exchange rate of US$1 to 20 pesos is implied. The peso is overvalued against the U.S. dollar by 33% (as per the calculation: (20-15)/15), and the dollar is undervalued against the peso by 25% (as per the calculation: (0.05-0.067)/0.067). In the arbitrage opportunity above, the actions of many Mexican fast-food shop owners selling pesos and buying dollars to exploit the price arbitrage would drive the value of the peso down (depreciate) and the dollar up (appreciate). Of course, the actions of exploiting a Big Mac alone is not sufficient to drive a country's exchange rate up or down, but if applied to all goods - in theory - it might be sufficient to move a country's exchange rate so that price parity is restored. For example, if the price of goods in Mexico is high relative to the same goods in the U.S., U.S. buyers would favor their domestic goods and shun Mexican goods. This loss of interest would eventually force Mexican sellers to lower the price of their goods until they are at parity with U.S. goods. Alternately, the Mexican government could allow the peso to depreciate against the dollar, so U.S. buyers pay no more to buy their goods from Mexico.

BIG MAC INDEX A CURRENCY COMPARISON:

THE Economists Big Mac index is a fun guide to whether currencies are at their correct level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of a basket of goods and services around the world. At market exchange rates, a burger is 44% cheaper in China than in America. In other words, the raw Big Mac index suggests that the yuan is 44% undervalued against the dollar. But we have long warned that cheap burgers in China do not prove that the yuan is massively undervalued. Average prices should be lower in poor countries than in rich ones because labour costs are lower. The chart above shows a strong positive relationship between the dollar price of a Big Mac and GDP per person. PPP signals where exchange rates should move in the long run. To estimate the current fair value of a currency we use the line of best fit between Big Mac prices and GDP per person. The difference between the price predicted for each country, given its average income, and its actual price offers a better guide to currency under- and overvaluation than the raw index. The beefed-up index suggests that the Brazilian real is the most overvalued currency in the world; the euro is also significantly overvalued. But the yuan now appears to be close to its fair value against the dollarsomething for American politicians to chew over. Read more in our Economics focus and leader.

The Big Mac index: - Currency comparisons, to go

Jul 28th 2011, by The Economist online

A beefed-up version of the Big Mac index suggests that the Chinese yuan is now close to its fair value against the dollar

Here, to know in depth about this concept we need to understand that what affects a currencies relative strength and for that we need to understand Forces behind Exchange Rates change.

FORCES BEHIND EXCHANGE RATE CHANGE:

1. Differentials in Inflation As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. 2. Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates. 3. Current-Account Deficits The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. 4. Public Debt Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future. In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.

5.Terms of Trade A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners. 6. Political Stability and Economic Performance Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.

THE LAW OF ONE PRICE AND PPP:

A strong version of the PPP theory has as its foundation the law of one price. Abstracting from complicating factors such as transportation costs, taxes, and tariffs, the law of one price states that any good that is traded on world markets will sell for the same price in every country engaged in trade, when prices are expressed in a common currency. For instance, consider the price of sesame seedsone of the basic ingredients of the Big Mac in Britain and the United States. Letting pss and pss$ represent the prices of sesame seeds in Britain (in pounds) and the United States (in dollars), respectively, then the law of one price can be expressed as follows: (1)

pss = e* pss$

where e is the pound/dollar exchange rate. If sesame seeds cost $6 per bushel in the United States and the pound/dollar exchange rate is 0.5, then the law of one price states that the price of sesame seeds in Britain should be 3. If sesame seeds sold for a price higher than 3, an astute trader could buy sesame seeds in the United States and sell them in Britain at a profit. This type of activityknown as arbitrage.

An Absolute PPP:
The law of one price generalizes to PPP under special circumstances. Consider price indices (consumer price indices, for example) for the United States and Britain, which are constructed by combining the prices of several different commodities. Typically, these indices are weighted averages of the individual prices. If the same goods are included in each index and if the price indices are constructed identically, then, according to the law of one price, the overall price levels P$ and P will be related in the same way as each of the individual commodities:

(2)

P* = e P$

where P* is the price level measured in the foreign currency and e is the foreign currency price of a dollar (foreign currency units per dollar). If PPP holds, then equation (2) can be rewritten as

(3) The expression on the left-hand side of equation (3) is referred to as the real exchange ratethe exchange rate adjusted by relative price levels.

India Ranks Low in Big Mac Index

After 25 years, India has finally made it to the Big Mac Index although, technically, the Big Mac isnt available in India.

The Big Mac Index looks at the price of a Big Mac burger, which is available in more than 100 countries. This is a simplistic way to demonstrate purchasing power parity, a theory that says that the exchange rate between two countries should move toward correct value, which would make the price of a basket of products the same in both countries. But despite being a crude measure, many economists and market pundits pay attention to the Big Mac index including the Reserve Bank of India. In a paper published in April, authors from the Indian central banks department of Economic and Policy Research, cited the 2010 Big Mac index when discussing how undervalued the Chinese yuan was. It remains to be seen if the RBI will endorse the findings of the index for the Indian rupee. The July 2011 index, published this weekend, included India for the first time since it was invented in 1986. It shows that India has the most undervalued currency among 37 major currencies 53% lower than the U.S. dollar. The index also shows the purchasing parity exchange rate between the Indian rupee and the U.S. dollar to be just 24.7. In other words, $1 can buy goods worth nearly 25 rupees in India. The actual exchange rate is 53.06 rupees for 1 U.S. dollar. For one thing, McDonalds doesnt even sell Big Mac in India because its made of beef which is not acceptable to Hindus. So, The Economist has instead looked at the price of the MaharajaMac burger, made of chicken. Its not even comparable, says Sumita Kale, an economist at Delhi-based research firm Indicus Analytics Pvt. Among other obvious flaws in the Big Mac comparison are the facts that labor is cheaper in India, and that most Indians cant even afford to buy a McDonalds burger. At 84 rupees ($1.89, using the nominal exchange rate), the Maharaja-Mac would require nearly 40% of the daily wage of an unskilled worker in Delhi (minimum wage in India varies by states). In comparison, the national hourly minimum wage in the U.S. is $7.25, nearly twice the cost of the Big Mac burger at $4.07.