Nov 06 2007

Burgernomics and Purchasing Power Parity

The Big Mac index | Economist.com

In IB Economics we’re studying the theory of exchange rates. A floating exchange rate system should be in equilibrium when the rate enables people in different countries to buy the same basekt of goods with an equal amount of money. In other words, If I walk into McDonalds in the US and have to pay $3.00 for a Big Mac, then board a plane, land in Shanghai and walk into a McDonalds there, the price I pay in Shanghai should, given current exchange rates, be the same as what I paid in the US. In reality, a Big Mac in Shanghai costs about 56% less than one in the US. This tells economists something about the value of the Chinese RMB.

If the price of a particular basket of goods for Americans is higher than the same basket of goods for Chinese given current exchange rates, than that would be a sign that the Chinese currency is undervalued. In the long-run, “exchange rates should move towards levels that would equalize the prices of an identical basket of goods and services bought in either of the two countries whose exchange rates are being compared.” This concept is known as Purchasing Power Parity (PPP).

China has been dealt harsh criticism and even been threatened with extreme protectionist measures (such as a proposed 27% tariff on all Chinese imports!) lately by the US in response to its interference in the foreign exchange markets to control the value of the Chinese Yuan. Many say that the yuan is grossly undervalued, giving China an unfair advantage over domestic producers in the US and elsewhere. As a closely managed yuan is kept artificially weak, Chinese products appear far cheaper than those from other countries, harming domestic industries in the US and elsewhere.

One way to test the level of undervaluation of the yuan is to apply the principle of PPP. If we could compare the price of a particular basket of goods (or even ONE good that can be bought in both countries), then we can determine whether at current exchange rates the RMB is under or over-valued. Luckily, the Economist magazine has developed its own measure of PPP, and it’s chosen one product that can be purchased in nearly every country in the world, the BIG MAC!

The table below shows by how much, in Big Mac PPP terms, selected currencies were over- or undervalued at the end of January… The most undervalued currency is the Chinese yuan, at 56% below its PPP rate; several other Asian currencies also appear to be 40-50% undervalued.

The index is supposed to give a guide to the direction in which currencies should, in theory, head in the long run It is only a rough guide, because its price reflects non-tradable elements—such as rent and labour. For that reason, it is probably least rough when comparing countries at roughly the same stage of development. Perhaps the most telling numbers in this table are therefore those for the Japanese yen, which is 28% undervalued against the dollar, and the euro, which is 19% overvalued. Hence European finance ministers’ beef with the low level of the yen.

Discussion Questions:

  1. What are the shortcomings of the Big Mac Index in depicting the true under or over-valuations of various currencies.
  2. How has China intervened in currency markets to maintain the value of the RMB at such a low level?
  3. What are two likely complaints the Europeans have against the value of the Japanese Yen? Are these similar to the complaints the US has against China?
  4. If the Chinese were to halt all interference in the currency markets, what do you think would happen to the value of the RMB? How would this affect the balance of trade between the US and China?

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

72 responses so far

72 Responses to “Burgernomics and Purchasing Power Parity”

  1. Bryan DiLauraon 14 Dec 2011 at 4:21 am

    1. What are the shortcomings of the Big Mac Index in depicting the true under or over-valuations of various currencies.
    There are differing costs involved in making a Big Mac in different areas of the world. For example, labor in China and India is much cheaper than in the United States (minimum wage). Also, some of the ingredients can have different costs in different parts of the world, like meat tomatoes etc.

    2. How has China intervened in currency markets to maintain the value of the RMB at such a low level?
    China has intervened into it's currency markets by keeping it at a fixed low value (pegged to the US dollar).

    3. What are two likely complaints the Europeans have against the value of the Japanese Yen? Are these similar to the complaints the US has against China?
    Europeans get concerned that their consumers will be attracted to the lower prices of Japanese goods. They are pretty much the same complaints the US has of China.

    4. If the Chinese were to halt all interference in the currency markets, what do you think would happen to the value of the RMB? How would this affect the balance of trade between the US and China?
    The value of the RMB would appreciate like crazy. Because it has been kept artificially low for a very long time, the value will not only go up to market value, but most likely shoot way past it. Soon, the opposite problem will happen for China. The US dollar will be less valuable in comparison, and China will experience all of the problems the US is facing now.

  2. Michael Mayeron 14 Dec 2011 at 6:15 am

    What are the shortcomings of the Big Mac Index in depicting the true under or over-valuations of various currencies?

    Local production costs of a big mac in particular might be different from that of other products, and therefore could affect the price regardless of exchange rates, and as such, not be a good measure of currency value.

    What are two likely complaints the Europeans have against the value of the Japanese Yen? Are these similar to the complaints the US has against China?

    Europeans might complain that the low value takes away from Europe's domestic sales, since people end up wanting to buy more goods from Japan. Yes, it is similar to US complaints. They complain also about this fact.

    If the Chinese were to halt all interference in the currency markets, what do you think would happen to the value of the RMB? How would this affect the balance of trade between the US and China?

    Most likely, the RMB would rise. It seems as though China is striving to keep the value down, because it augments exports and decreases imports. This would affect trade between the US and China in that the US would suddenly import fewer goods from China, and export more goods to China.

  3. Haleigh Eppleron 14 Dec 2011 at 6:41 am

    What are the shortcomings of the Big Mac Index in depicting the true under or over-valuations of various currencies.
    The Big Mac Index uses the value of a single product to evaluate the worth of an entire currency. Using one product allows for misrepresentations of the data because their are costs involved in the creation of the product: produce, meat, and labor, which vary from country to country. While one country may have inexpensive labor, they may have expensive metals. The two counteract each other; however, they are not both considered in the big mac.

    How has China intervened in currency markets to maintain the value of the RMB at such a low level?
    China has pegged the RMB to the dollar. The dollar is kept strong because when there is an influx of dollars on the market, China purchases them lowering the supply and raising the demand causing the value of the dollar to increase. Because China can manipulate the dollar, and the RMB is pegged to the dollar, China is able to maintain lower values.

    What are two likely complaints the Europeans have against the value of the Japanese Yen? Are these similar to the complaints the US has against China?
    Europeans would argue the Yen is kept artificially low. The low value results in unfair advantages in the global market resulting in greater exports for Japan and more imports for Europe changing the Balance of Payments such that Europe is more likely to run a deficit. These complaints are similar to those the US has against China.

    If the Chinese were to halt all interference in the currency markets, what do you think would happen to the value of the RMB? How would this affect the balance of trade between the US and China?
    I believe the value of the dollar would decrease and the value of the RBM would increase. If China stopped buying dollars, the supply of dollars would dramatically increase, possibly beyond a level which is safe for the economy, and the RBM would increase because of the surplus in trade. However, the decrease in the value of the dollar, and the increase in the value of the RBM would alter the balance of trade so that each country was closer to an even zero balance.

  4. djohnon 17 Dec 2011 at 6:13 pm

    1. What are the shortcomings of the Big Mac Index in depicting the true under or over-valuations of various currencies.
    • There are many factors that affect the Big Mac Index in depicting the true under or over valuations of various currencies. One such factor is the different price levels for the ingredients needed to produce the product. The price of the beef patty will differ in China and in American as in China it may be imported whereas in American it might be from a domestic firm. Some other factors include capital goods such as labour needed in the restaurant as in different countries different wages are paid. Machinery is another factor as some countries have different machines for producing the Big Macs and in each country the cost of these machines differ. Tax is another factor that affects the shortcomings of Big Mac and exchange rate.
    2. How has China intervened in currency markets to maintain the value of the RMB at such a low level?
    • China has lowered the values of the RMB to make exports for foreign countries more attractive so that more countries trade with China increasing its profits as China exports more than it imports. This maintains the value of the RMB at such a low level.

    3. What are two likely complaints the Europeans have against the value of the Japanese Yen? Are these similar to the complaints the US has against China?
    • Since the value for yen in undervalued by 28% against the dollar and overvalued by 19% against the euro it is not exactly the same complaint but can be accounted for being similar to the American-Chinese complaints. This is because the Europeans argue that the value of the yen is devalued making the Japanese products in Europe cheaper. This affects the domestic firms in Europe as demand for cheaper products rises.
    4. If the Chinese were to halt all interference in the currency markets, what do you think would happen to the value of the RMB? How would this affect the balance of trade between the US and China?
    • In the future the value of the RMB will rise significantly as demand for Chinese products in American will rise due to the cheap prices. But at the same time this will also create problems as exports from China will decrease as the price will increase causing Americans to reduce their purchase of Chinese products.

  5. djohnon 17 Dec 2011 at 6:24 pm

    @ Haleigh Eppler
    Your answers are very well written. I do agree that the Europe and Japan situation is similar to the American and Chinese situation but with how much America already has, such as resources and raw materials do you think they are going to reduce exports and increase imports? Won’t they still continue to trade as much as they were trading now.

    Good answers though 🙂

  6. Muhammet Murat SEKBANon 20 Dec 2011 at 7:17 pm

    1. What are the shortcomings of the Big Mac Index in depicting the true under or over-valuations of various currencies.
    The taxes, the cost of prodution are taken into account. Since each country has different capital reasources, the cost of prodution becomes various. Moreover, different currincies are also shortcomings of Big Mac Index.
    2. How has China intervened in currency markets to maintain the value of the RMB at such a low level?
    Since China’s level of import is much lower than level of exports therefore the RMB is low.
    3. What are two likely complaints the Europeans have against the value of the Japanese Yen? Are these similar to the complaints the US has against China?
    Since the Japanese Yen is very cheap, the Europeans might argue that the Japanese takes the advantage of it and keep their export costs low. The US has similar complaints against China because Yen is undervalued against euro.

    4. If the Chinese were to halt all interference in the currency markets, what do you think would happen to the value of the RMB? How would this affect the balance of trade between the US and China?
    The value of RMB will appreiates which means produts of China will beome expensive too. Since China produts has less demand, exports will decrease. As a result of this, foreign investments will decrease in China and the fact of high value of Money, inflation may happen.