Estimating the Purchasing Power Parity (PPP) of currencies using the Big Mac Index™
Table of Contents
2. Purchasing Power Parity and Theory of one Price
3. Over/Under Valuation of currencies against the Dollar
5. Comparative analysis of the most overvalued to the most undervalued 6. Observation and Alternative indexes
Purchasing power parity (PPP) is an important and critical topic in international economics. It arises when the purchasing power of an amount of money is the same in different countries. This is when prices of two different countries are converted to a common currency. The idea is based on the law of one price, where in the absence of official trade restrictions, similar goods will have the same price in different markets, with the prices being expressed in the same (common) currency. Deviations from parity infer differences in purchasing power of goods across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPP adjusted" and converted into common units. There can be a huge difference when adjusted by purchasing power and when converted via market exchange rates. For ex:- If calculated at nominal exchange rates, India has the tenth largest economy while adjusting by PPP, India has the fourth largest economy. Thus, to remove this discrepancy, a common currency of measurement is highly essential. The Big Mac Index is an example of a measure of law of one price. It refers to the prices of a Big Mac burger in McDonald's restaurants in different countries. It helps in determining whether a currency is undervalued or overvalued and thus accordingly gives an idea about the direction in which currencies should move. The Big Mac was selected because it is available for a common purpose in many countries around the world as local McDonald's franchisees have significant responsibility for converting input prices(at least in theory).The Big Mac Index is useful because it is based on a very well-known food item whose final price can be easily tracked in many countries.
PPP and the Theory of One Price
The One-Price Theory
The theory of PPP and One price go hand in hand. It is imperative to understand the implication of “One Price” to understand the Purchase Power Parity as it is based on that. The Law of One Price proposes that if a gadget costs $2 in USA and the same gadget costs Rs 5 in India , then the exchange rate should be 2/5 = 0.40 for the real prices to be same in both the countries. Let us denote it empirically as Price of a good in one country A be X and Price of the same good in some other country B is X* , then equalization of both the prices can be done using exchange rate denoted by the formula Exchange Rate = X/X*
Suppose in the above example where the exchange rate is calculated to be 0.4, increases to 0.6, and then the same gadget would cost Rs 8.33 in India. This would result in the inflow of gadgets to India from USA causing increase in the demand of dollars and increase in supply of Rupees. Law of One Price (LoOP)
It states that identical goods should sell at same price in two different markets when there are no transportation costs and no differential taxes applied in two markets One Price Theory and PPP
While this concept of one –price here in the example is being applied to one commodity, it can be applied universally to all other commodities in market as well. The Big Mac burger is one of the brightest examples of the application of One-Price to a commodity. It looks at the price of a big Mac burger across different countries. This way Purchase Power Parity applies not just to a single commodity but on general price level. This way we can universally derive a relation of One-Price theory and Purchase Power Parity.
The Big Mac was created by Jim Delligatti in the year 1967 and introduced throughout the...
Please join StudyMode to read the full document