The Big Mac Index Essay

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STUDENT NUMBER: 092008164 The Big Mac index is published by the Economist, It is purely 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 whole world. In simple words we take a ‘MacDonalds Big Mac’ as the benchmark and compare its price in the 120 countries in the world where it is sold and produced. Let us take an example, suppose the price of a Big Mac in the U. S is $3 and for the same burger in the UK it is ? 2.

Looking at this the exchange rate would be 3 divided by 2 which would give us 1. 5. Now if the exchange rate of dollars to pounds was greater than 1. 5 it would mean the pound was overvalued and less than 1. 5 it would be undervalued. According to the index above average price of a Big Mac in the US is $4. 07, In Malaysia it is $2. 42 at the market exchange rates which means it is 40% cheaper. To make both the prices equal it would require an exchange rate of 1. 77 to the dollar (Ringgit 7. 20 divided by 1. 77). This also suggests that the Malaysia Ringgit is undervalued by 40% against the dollar.

Since the index is based on PPP we now look at what it means and the two types of conditions that go with it. STUDENT NUMBER: 092008164 Purchasing Power Parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of goods between countries would only reflect the exchange rates. Identical products sold in different markets will sell at the same price when expressed in terms of a common currency in the presence of a competitive market structure and absence of transport costs and other barriers to trade.

PPP is based on the ‘Law of one price’ which is based on the idea of perfect good arbitrage. Absolute Purchasing Power Parity is a concept where the exchange rate between two countries will be identical to the ratio of the price levels of the two countries. If we take a good in one country, compare the price of that good in another foreign country, convert by the exchange rate in to a common currency then these two prices must be the same always. If a good is sold at different prices in two states than traders will realize profit by buying it in a low ost country and selling it in a high cost country. Thus, in the absence of transportation costs and trade impediments, the prices of goods will converge. S=   P ? P* S is the spot exchange rate between two countries (the rate of amount of foreign currency needed to trade for the domestic currency), P is the price index for a domestic country and P* is the price index for a foreign country. If there is a price rise in the home country relative to a foreign country there will be a proportional depreciation of the home currency relative to the foreign currency.

Relative Purchasing Power Parity relates to the changes in two countries’ expected inflation rates to the change in their exchange rates. Inflation reduces the purchasing power of a nation’s currency so relative PPP examines the changes in price levels between two countries and maintains that exchange rates will compensate for inflation differentials. This is a weaker form of PPP but it holds in the presence of the existence of transport costs, imperfect information and the distorting effects of tariff and non tariff barriers to trade. This is expressed as %?

S=%? P – %? P* Where % ? S is the percentage change in the exchange rate, %? P is the domestic inflation rate, and %? P* is the foreign inflation rate. There are a significant amount of problems regarding the Big Mac index. Firstly burgers cannot be traded across borders and prices are distorted by differences in taxes and the cost on non-tradable inputs such as rents. In many developing countries eating at major international fast food chains such as McDonalds is relatively expensive than in local outlets so the Demand for burgers varies from country to country.

The consumption for burgers in the US will be much higher than in India. PPP also lumps items together in to broad classes, not taking in to account things such as quality and so its value in the index remains static. Furthermore, the price of the Big Mac does not only consist of the ingredients but also staff wages, marketing costs etc. Since McDonalds doesn’t do as much marketing in some countries as it does in others and people don’t have the same hourly wage in every country so the price of the Big Mac isn’t reliable. STUDENT NUMBER: 092008164 PPP comparisons are more reliable between ountries with similar levels of income since PPP does not hold between developing and developed nations. It is for the fact that the price of non-tradable goods and services (local costs such as rents, wages etc. ) in developing countries is significantly lower than in developed countries. PPP based on tradable goods will undervalue the purchasing power in poor countries because they can buy more non-traded goods per dollar. This means $50 will tend to buy far more restaurant meals, hotel time and many other goods and services when transferred in to the local currency of a developing country than in a developed one as PPP will not hold.

Exchange rates also tend to be undervalued in terms of purchasing power for goods and services. The Developing nation’s people also spend a huge proportion of their income on basic necessities than the developed world thereby causing the distortion. The Balassa-Samuelson model is helpful in explaining why it is the rich countries who overall have high price indices and poor countries low price indices when an aggregate basket of traded and non traded goods are converted in to a common currency such as the US dollar. GDP per capita based on PPP is a more reliable guide to relative living standards than using the market exchange rate.

STUDENT NUMBER: 092008164 To estimate the fair value of the currency we use a ‘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 over valuation than the ‘raw index’. The chart below shows a strong positive relationship between the dollar price of a Big Mac and GDP per person. In overall the Big Mac numbers should be taken with a pinch of salt as they are not a precise indicator of currency movements.

Even though some politicians have started to take it seriously it is still a light hearted form to look at currencies. EC 3067- INTERNATIONAL FINANCE ASSIGNMENT QUESTION: The Big Mac index is a light hearted attempt to gauge how far currencies are from their fair value. It is based on the theory of purchasing power parity (PPP). Describe how the index is constructed and what type of information you can take from it. Discuss the potential problems of such an index and explain why PPP comparisons are more reliable between countries with similar levels of income.

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