BigMac Index

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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 ar
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  Purchasing Power parity &The Big Mac Index Abstract  This paper looks into the issue of purchasing power parity (PPP) and the debate surrounding itsexistence in the short run. It includes a brief discussion on the implications of PPP in the macro-economic and consumer level. Special focus is placed on the relationship between wages andreal exchange rates across countries. The paper attempts to discover the extent to which short-term departures from PPP can be attributed to wages. Conclusions are drawn from the resultsof 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 pricein 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 tothe economic theory of Purchasing Power Parity (PPP). PPP states that price levels in any twocountries should be identical after converting prices into a common currency and afteraccounting 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 inevery country engaged in trade, when prices are expressed in a common currency. The reasonfor this is the possibility of international goods arbitrage, which allows an Individual to make arisk-less profit by taking advantage of price differentials (i.e., buying a product from a low pricedcountry and selling the same product at the high priced country). These individual activitiesmagnified at the macro, international level will cause the supply adjustments that will lead to theconvergence 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 growthand the extent of inequality between rich and poor countries. It also makes the appropriateranking of countries in terms of the relative size of economies more ambiguous. Take China forexample. Using simple market exchange rate conversions, its economy can be ranked as the 7 largest in the world. However, after adjusting for PPP, China‘s ranking moves up to the 2 largest in the world, just behind the United States (The Economist 2004b). This illustrates thatcurrencies can be grossly over-valued or under-valued at a given point in time. Therefore, theuse 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 theprice of McDonald's Big Mac burger in many countries since 1986. This experiment - known astheBig Mac PPP- and similar tests have been underway for decades. Here we take a look atthis unique indicator, and find out what the price of the ubiquitous Big Mac in a given countrycan tell us about its wealth. What is Big Mac Index? The Big Mac Index is an informal way of measuring thepurchasing power parity(PPP)between twocurrenciesand provides a test of the extent to which marketexchange ratesresult 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 toevaluate the purchasing power parity of various currencies around the world. Although it is asimplification of the complex issues surrounding the international monetary system, it can serveas a proxy for the consumer price index (CPI) because the Big Mac® is served in 120 countriesaround 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 realexchange rates are highly correlated with the CPI-based real exchange rates both in levels andin first differences (2003). So the lessons from the Big Macs have general implications for CPI-based real exchange rates.The Big Mac Index has been derived from publications of The Economist  magazine. Thedataset includes Big Mac prices in the local currency and its corresponding price in US dollarsbased on the prevailing exchange rate at the time of publication. The US dollar was used as thenominal base currency2. As of 2004, The Economist has included up to 42 countries in the BigMac Index. However, many countries have only been recently added and do not have completehistorical data. For example, coverage for some countries started at later years like 1994 forPoland, 1996 for South Africa, 2001 for the Philippines, and 2002 for Turkey. Meanwhile, BigMac Index data for countries like Ireland, Portugal, and Israel becomes unavailable starting on1994, 1995, and 2001 respectively. Of most significant impact to the data source is theintegration of the currencies of several European countries in 1999. When the physical currencybecame available in January of 2002, prices for Big Macs throughout the euro area were postedin euros and The Economist ceased from reporting prices of Big Macs for individual euro areacountries.The inconsistency and data lapses in BMI information means only a subset of the entire timeperiod covered is reliable enough to include in the dataset. For the purpose of this analysis, thetime period from 1992 to 2001 will be used in order to have a complete series of contiguousdata available for at least a 10-year period. Fourteen countries out of the 42 covered as of 2004are able to meet this criterion.Using the reported Big Mac prices during this period and the prevailing monetary exchangerates for each corresponding year, real exchange rates can be calculated using the followingformula: 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 where100 equates to parity. Values below 100 indicate that the local currency is undervalued relativeto the US dollar and values above 100 indicate that the local currency is overvalued relative tothe US dollar. Table 1 displays the mean, minimum, and maximum values for each of the 14qualifying countries.   Relation between Big Mac and PPP:( Hamburger Economics: The Big Mac Index )   To illustrate PPP, let's assume the U.S. dollar /Mexican pesoexchange rate is 1/15 pesos. If theprice of a Big Mac in the U.S. is $3, the price of a Big Mac in Mexico would be 45 pesosassuming the countries have purchasing power parity.If, however, the price of a Big Mac in Mexico is 60 pesos, Mexican fast-food shop owners couldbuy 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, theconcept 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 isbecause it would cost them 60 pesos to buy U.S. Big Macs, which is the same price as inMexico  – thus restoring PPP.PPP also means there will be parity among prices for the same good in all countries (the law ofone 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 exchangerate of US$1 to 20 pesos is implied. The peso is overvalued against the U.S. dollar by 33% (asper the calculation: (20-15)/15), and the dollar is undervalued against the peso by 25% (as perthe calculation: (0.05-0.067)/0.067).In the arbitrage opportunity above, the actions of many Mexican fast-food shop owners sellingpesos 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 aloneis not sufficient to drive a country's exchange rate up or down, but if applied to all goods - intheory - 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 wouldeventually 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, soU.S. buyers pay no more to buy their goods from Mexico.
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