Currency Valuation and Purchasing Power Parity
Jamal Ibrahim Haidar - April 2011
The analytical framework of currency valuation is
an intellectual challenge and of influence to economic policy, smooth
functioning of financial markets, and financial management of many
international companies. The Economist magazine argues that the Big Mac Index
(BMI) based on the price of a Big Mac hamburger across the world can provide “true
value” of currencies.
The purchasing power parity (PPP)
theory postulates that national price levels should be equal when expressed in
a common currency. Since the real exchange rate is the nominal exchange rate
adjusted for relative national price levels, variations in the real exchange
rate represent deviations from PPP. It has become something of a stylized fact
that the PPP does not hold continuously. British prices increased relative to
those in the US over the past 30 years, while those of Japan decreased.
According to PPP theory, the British pound should have depreciated (an increase
in the pound cost of the dollar), and the Japanese yen should have appreciated.
This is what in fact happened. Despite deviations in the exchange rate from
price ratios, there is a distinct tendency for these ratios to act as anchors,
for exchange rates. Thus, exchange rate reverts to the price ratio, which can
be considered the “true value” of the currency.
In 1986, The Economist magazine created a tool for making PPP
comparisons. This tool uses the price of a Big Mac hamburger at home and abroad
as the price ratio that reflects the “true value” of the currency. This ratio
represents the BMI; it is the nucleus of “burgernomics”.
The BMI gives a signal about under-valuation and over-valuation of currencies,
relative to the actual exchange rate. The PPP school of thought is among the
oldest research areas in international finance. The PPP stands as a general
form of the law of one price in the geographical arbitrage presence for the
same goods at different location. The PPP holds only within strict circumstances
– i.e. lack of central bank interventions, trade restrictions, transaction
costs, and taxes. A reference to PPP helps determine whether foreign exchange
market precisely prices a currency because a currency, typically, revert to its
PPP value over time. The BMI currency pricing model is well embedded in the PPP
theory. It is a case of interaction between financial journalism, basic
economic research, and foreign exchange markets.
This paper uses the occasion of the 25th anniversary of
the introduction of the Big Mac Index to provide a broad evaluation of its
workings and performance. While the BMI is not perfect, it provides hints about
the operation of foreign exchange markets. Part 2 provides a literature review
about “Burgernomics”, presents evidence about the BMI,
and summarizes the PPP theory debate. Part 3 discusses a set of BMI methodological
limitations and clarifies the BMI bias. Part 4 concludes.
The literature on PPP is large and growing. Froot
and Rogoff (1995), Lan and Ong (2003), Rogoff (1996), Sarno and Taylor (2002), Taylor and Taylor (2004) and
Taylor (2006) are a subset of available literature reviews on the matter. Click
(1996), Ong (1997) and Pakko
and Pollard (1996) are among the early contributors to academic research on the
BMI while more recent papers include Chen et al. (2007) and Clements et al. (2010).
Empirically, studies found heterogeneous results while testing PPP. Frankel
(1979) studied the correlation between exchange rates and inflation (proxied by CPI and then by WPI)
in 1920s, finding PPP-supportive results in hyperinflation economies. However,
using same inflation indicators, the same author, among others,
rejects PPP for developed countries during 1970s. Nonetheless, inflation and
exchange rate nonstationarity invalidates these
findings by showing the shortcomes of conventional
testing methods. Meanwhile, more recent research
rejected PPP validity (i.e. real exchange rate mean reversion) by utilizing
cross-country datasets while Frankel and Rose (1996) empirically validated PPP
The above studies, which use CPI or WPI, have at least two
shortcomings. First, non-tradable goods affect CPI and WPI relative usage
across countries. Second, regardless of whether the law of one price holds in a
certain market for a specific commodity, CPIs and WPIs behave differently when
consumption bundles are not identical, leading to PPP tests biased outcomes.
Hence, these price indices can lead to heterogeneous results while testing PPP
validity. Recent studies have shifted their attention to using another price
index as a study target. Cumby (1996) used The Economist's BMI, given its
uniform composition feature as the Big Mac ingredients are identical across
countries, to assess PPP. The use of the Big Mac decreases the estimation bias
given it meets the “identical good” requirement in the law of one price testing
process. However, it does not meet all the requirements of the law of one price
– i.e. barriers to trade, wage rate, taxes, and productivity differentials.
The demand for fast food varies across countries. For instance, the
North American relationship with the Big Mac is much more ingrained into
culture then it is in Asian cultures. For this reason, a direct comparison using
Big Mac Index (BMI) has some problems. First, food regulations differ across
countries. For example, Switzerland and the Euro area have much more strict
food regulation laws (Switzerland in particular) than United States. This fact
means the cost of "better" beef or other parts of a Big Mac is higher
in the Euro area. Second, there is the social perception and price differential
of McDonalds in the different countries. In Switzerland and much of Europe,
McDonalds is more of a "nice" place. It is not surprising for
McDonalds in Europe to have multiple stories and in Switzerland there are video
game systems and lounges. In Ukraine, one of the places to meet
and relax is McDonalds. This matter means that, in general, they are located in
better places and have higher rent payments in Europe. Also, richer people visit
the McDonalds in Switzerland and the Euro area and will continue to pay for
such goods despite the price. In the United States, however, McDonalds is typically
a cheaper place to eat and restaurants would lose a lot more money by
increasing prices than European McDonalds’. With variations like this, the BMI
perpetuates a false idea that a critical analyst can discover anything at all
about purchase power parity by comparing hamburgers.
The theory of purchasing-power parity (PPP), the notion that a
dollar should buy the same amount in all countries, implies that in the long
run, the exchange rate between two countries should move towards the rate that
equalizes the prices of an identical basket of goods and services in each
country. However, the United States, along with most developed economies,
subsidize meat, bread (which is made of wheat), lettuce, tomato, eggs,
potatoes, and all farm products in a Big Mac burger. Also, these countries exercise
protectionism on those products as well as adopt a mercantilist approach in the
international market. Thus, how can a Big Mac be a comparable item? For any
product to be useful on that purpose, it should be freely-tradable between
countries, with no country subsidizing or taxing it more than another country. Therefore,
the Big Mac is less appropriate to compare the prices since it would be cheaper
in countries who subsidize farm products - and it may lead to a distorted
A “weak” currency, despite its appeal to exporters and politicians,
is no free lunch. But it can provide a cheap one. In China, for example, a
McDonald's Big Mac costs just 14.5 Yuan on average in Beijing and Shenzhen, the
equivalent of $2.18 at market exchange rates. In United States, in contrast,
the same burger costs, on average, $3.71. A difference of this significance
makes China's Yuan one of the most undervalued currencies in the most recent
Big Mac index, leading to currency misalignments. Since the BMI is based on the
idea of purchasing-power parity, and 14.5 Yuan can buy as much burger as $3.71,
a Yuan should be worth $0.26 on the foreign-exchange market. In fact, it costs
just $0.15, suggesting that it is undervalued by about 40%. In Brazil a Big Mac
costs the equivalent of $5.26, implying that the real is overvalued by 42%. The
index also suggests that the euro is overvalued by about 29%. And the Swiss
franc is the most expensive currency, according to the BMI list. The Japanese
are so far the only rich country to intervene directly in foreign exchange
markets to weaken their currency. But according to BMI, the yen is only 5%
How can The Economist justify this misalignment? It can rely not on
Big Macs, but on three less digestible approaches. First, it can calculate the
real exchange rate that would steadily bring a country's current-account
balance (equivalent to the trade balance plus a few other things) into line
with a “norm” based on the country's growth, income per person, demography and
budget balance. Second, it can ignore current-account balances and instead
calculate a direct statistical relationship between the real exchange rate and
things like a country's terms of trade (the price of its exports compared with
its imports), its productivity and its foreign assets and liabilities. The
strength of Brazil's currency, for example, may partly reflect the high price
of exports such as soya beans. Third, it can also calculate the exchange rate
that would stabilize the country's foreign assets and liabilities at a
reasonable level. If, for example, a country runs sizeable trade surpluses,
resulting in a rapid build-up of foreign assets, it probably has an undervalued
exchange rate. Indeed, the raw index did a poor job of predicting exchange
rates: undervalued currencies remain too cheap and overvalued currencies remain
too expensive. And, such misalignments are remarkably persistent. They give a
signal of a systematic bias showing that the BMI may itself be undervalued.
The Big Mac Index does have other shortcomings. A Big Mac's price
reflects more than just the cost of bread and meat and vegetables. It also
reflects non-tradable elements - such as rent and labor. For that reason, the
Big Mac Index probably is best when comparing countries at roughly the same
stage of development. In any case, there is no theoretical reason why prices of
non-tradable goods and services should be equal in different countries. This
fact explains why PPPs are different from market exchange. The BMI is an
interesting way to get a snapshot of comparative countries and their exchange
rates. However, domestic prices (inflation) and the local domestic economy also
play a role in determining the prices.
In the absence of trade barriers, dollar price of a
certain good should be identical across countries, according to the PPP theory.
Given the price of a Big Mac captures more than the (tradable) components cost
– i.e. restaurant space lease, heating and cooling utilities, electricity costs,
and wages – the price of the good would be expectedly different across
countries. These are non-tradable goods examples. For instance, the location of
the property cannot be traded although the property itself can be traded and
transferred between owners. Also, the use of labor non-tradable
given labor restrictions to move across borders to benefit from wage
differentials. Thus, although the
price of a restaurant rent space is lower in Sofia than
in Paris, it would not be feasible to do so if the purpose is to serve meals in
Paris. Rent and utilities contribute to the cost (and price) of a Big Mac, causing
deviations from PPP by reflecting cost differences across countries.
Non-tradable goods represent 94 percent of the Big Mac price.
The Big Mac provides evidence about why systematic deviations from PPP exist.
The next section considers a key PPP failure
the existence of barriers to trade. The PPP does not hold, at minimum in the
absolute terms, partly because of high cost of trading goods across borders.
The limitations of international
movement of goods include tariffs, export taxes, transportation costs, and
other government-imposed trade barriers, which contribute to price
Although the cost of transporting corn oil needed for the Big Mac may
not be high, transporting perishable components such as beef, cheese, and
lettuce is more costly. Thus, Transportation costs may drive price differential
for same good across markets. In 2002, a Big Mac cost $2.38 in the euro area,
11 cents less than the price in the United States. Although such price
differential may violate PPP, Big Macs (or Big Mac components) transportation across
borders may not necessarily occur. In theory, trade may occur, in this case,
conditional on whether the Big Mac transportation cost is less than 11 cents. Hence,
one might expect absolute PPP to hold only approximately, with prices diverging
within a range determined by the transport costs.
Using tariffs while practicing protectionism, countries impose
import restrictions, for instance, on farm products to protect certain
industries. The presence of tariffs on imported goods and import quotas constitutes
another significant factor of trade restrictions. Cassel (1921) studied the effects
of trade restrictions, stating, “If trade between two countries is more
hampered in one direction than in the other, the value of the money of the
country whose export is relatively more restricted will fall, in the other
country, beneath the purchasing power parity.” The author noted that export and
import restrictions have opposite effects on PPP. In monetary terms, on a PPP
basis, the economies with fewer restrictions on imports will have relatively
undervalued currencies. In simpler language, the BMI would be informative on
which economies impose more restrictions on agricultural products trade,
assuming no other PPP deviation drivers, compared to United States. For instance,
among the countries that imposed high import tariffs on beef during the BMI
life are Korea and Japan. Beef imports to Japan, until 1991, were subject to
quotas and tariffs. In addition, tariff
came into place in Japan during 1991 and in Korea during 1995. On a related
side, Korea imposed a 30 percent tariff on beef imports, for 5 years up to
1994, along with other trade barriers. It cancelled the import quot e
and set the tariff rate at 41% in 2001, allowing it to decrease to 40% by 2004.
A key driver of the beef price differential between Japan and Korea, and other
countries, in this case, is factored by such trade barriers, which provide
partial reasoning, as well, to the Japanese yen and the Korean won
overvaluation against the dollar until late 1990s. However, the United States
also restricts the volume of beef imports from all countries apart from Canada
In April 2002, McDonald's began buying some imported beef from Australia and
New Zealand for its U.S. operations. The quota, however, limits the extent to
which McDonald's can use imported beef to offset hamburger price pressures. In
addition, the higher barriers to trade in beef in the United States may partly
explain why the U.S. dollar has been consistently overvalued relative to the
Australian and New Zealand dollars. In a nutshell, compared to United States,
economies with less trade restrictions would be expected to be associated with
The existence of different taxation schemes across countries
contributes to PPP deviations. The Economist BMI uses sales and VAT (value
added taxes) tax-inclusive prices. Thus, ceteris peribus,
higher taxes would be associated with overvalued currencies on the BMI.
Simultaneously, tax adjustments would lead to BMI parities shifts. For example,
in 1991 Canada imposed the Goods and Services Tax, a national 7 percent sales
tax. Between 1990 and 1991, the price of a Big Mac rose from C$2.19 to C$2.35.
As a result, the Canadian dollar moved from being undervalued by 14 percent
against the U.S. dollar to being undervalued by only 9 percent. It would be
misleading, however, to say that the imposition of this new tax brought United
States and Canada closer to PPP.
The BMI and other price indices include non-tradables.
Samuelson (1964) and Balassa (1964) proved that
non-traded goods systematically influence PPP deviations due to productivity
differences across countries, industries, and sectors. They also showed that
low-income countries will have under-valued currencies compared to high-income
countries, assuming that economies with higher GDP per capita levels reflect,
to a certain extent, higher labor productivity.
Moreover, given competition for workers in each of non-traded and
traded goods sectors, wages are higher in high income economies, which are
associated with more labor productivity in traded goods sectors. Wages in the
service sector are lower in low income economies, leading to lower prices in
low income economies.
The, regardless of whether
prices of traded goods are identical across countries , lower service
prices transmit s to lower price levels in low income
economies. In different terms, the currencies of low income economies would
appear undervalued compared to currencies of high income economies. Turning to
Big Macs, it is unlikely that there are large differences in the productivity
of workers cooking burgers regardless of the country of location of the
McDonald's. There are, however, large differences in the wages earned by these
workers. This difference in wage costs may partly explain why the yuan and the zloty have been consistently undervalued
against the dollar as measured by BMI. In fact, according to the Balassa-Samuelson theory, holding all other things
constant, the dollar should be overvalued against the currencies of low income
Differences in government expenditures across economies may lead to
relative prices deviations from exchange rate. Governments spend
less on traded goods than do
es the private sector (households and
businesses). When government spending, for instance, in the United States
decreased compared to government spending in other countries, the price of
non-traded goods in the United States will decrease as will the overall price
level. If PPP held prior to this expenditures decline, the United States
currency will be undervalued relative to its PPP level. Another role for
non-traded goods in explaining deviations from PPP comes through the current
account. Krugman (1990) argued that, as a country
runs a current account deficit, its spending on traded goods increases
relative to other countries. This argument results in a decline in the relative
price of non-tradable goods in the deficit country. Thus, if PPP had held prior
to the current account deficit, the country's currency would then be
Firms can optimize profits by charging different prices across
countries when they are capable of pricing to market depending on product
demand elasticity. When demand of a good is inelastic (elastic), prices and
sales revenues are positively (negatively) associated. At the same time, firms
that price to market across countries or markets may limit exchange rate
pass-through, the extent to which changes in the exchange rate result in
changes in import prices.
When imports prices do not change exactly according to foreign
currency valuation patterns, then exchange rate pass-through is incomplete,
leading to a price differential between domestic and foreign markets. In order
to sustain relative sales and profit margin levels when currency value changes,
a firm may control pass-through in markets where demand is relatively elastic.
Certain factors shape firms ability to price to market - i.e.
warranty restrictions, the resale probability across markets, business
regulations, safety standards, wholesalers authorizations, and pollution
criteria. In the case of the Big Mac sandwich, obviously, unlike its
ingredients, it is not subject to resale across markets. While ingredients can
be purchased to create a competing sandwich, in many countries there are few
substitutes to Big Mac sandwich, unlike the case in United States. Thus, it is
reasonable to conclude that the Big Mac is not all about the ingredients. Other
factors, including people's interests, shape Big Mac demand
curve - and such factors shape also the pricing-to-market strategies. For
instance, while young Koreans perceive McDonald's as a fancy place to hang out
at, their peers in United States perceive it as no more than a low priced
The Economist magazine has been publishing the Big Mac Index for the
last quarter a century. The purpose of the indicator, according to The
Economist, is to show "real valuation" of currencies, mainly by
assuming PPP theory holds. This paper shows why the BMI does poorly as a
valuation tool as well as a forecasting mechanism. It presents various angles of
the PPP theory and highlights how each of them reduces the effectiv
one-product currency valuations indicators such as the BMI. Various studies assessed
the validity of PPP theory by using different inflation measures across
countries. This paper adds to the literature by showing, using PPP theory
framework, why the The Economist's BMI currency
valuation indicator should be perceived with caution, by highlighting its
characteristics from tradable commodities and non-tradable service components.
It clarifies that the BMI can actually be perceived as a good example of how,
when, and why the PPP does not hold.
Prices differ across countries for reasons not related to the value of
currency. For instance, even the price of one product (i.e. Big Mac sandwich)
is not constant within the same country (i.e. United States). In this case, the
BMI says that the value of dollar, compared to other countries, is not the same
across two differnt areas in the United States. This
observation is hard to digest as a credible currency valuation mechanism.
Future research can look further at the contributions of country borders t p
Gustav. “The World's Monetary Problems.” London: Constable and Company, 1921.
C.-F., C.-H. Shen and C.-A. Wang (2007). “Does PPP
hold for Big Mac price or consumer price index? Evidence from panel cointegration” Economics Bulletin.
Kenneth W, Yihui Lan &
Shi Pei Seah, 2010. "The Big Mac Index Two Decades On An Evaluation Of Burgernomics,"
Economics Discussion / Working Papers 10-14, The University of Western
Australia, Department of Economics.
Reid W. “Contrarian MacParity.” Economics Letters,
November 1996, 53(2), pp. 209-12.
Robert E. 1996. "Forecasting
Exchange Rates and Relative Prices with the Hamburger Standard: Is What You
Want What You Get With McParity?," NBER
Working Papers 5675, National Bureau of Economic Research, Inc.
J. A. .On the Mark: A Theory of Floating Exchange Rates Based on Real Interest
Economic Review, 69, 4, September 1979, pp. 610-22.
Jeffrey A. & Rose, Andrew K., 1996. "A panel project on purchasing power parity: Mean reversion within and
between countries," Journal of International Economics, Elsevier,
vol. 40(1-2), pages 209-224
Froot, Kenneth A. and
Rogoff, Kenneth. “Perspectives on PPP and Long- Run
Real Exchange Rates,” in Gene Grossman and Kenneth Rogoff,
eds., Handbook of International Economics. Volume 3. Amsterdam: North Holland
Krugman, Paul R.
“Equilibrium Exchange Rates,” in William H. Branson, Jacob A. Frenkel, and Morris Goldstein, eds., International Policy
Coordination and Exchange Rate Fluctuations. Chicago: University of Chicago Press,
1990, pp. 159-87.
and L. L. Ong (2003). “The Growing Evidence on
Purchasing Power Parity.” In L. L. Ong The Big Mac
Index: Applications of Purchasing Power Parity. UK: Palgrave MacMillan. PP.
L. (1997). “Burgernomics: the Economics of the Big
Mac Standard.” Journal of International Money and Finance 16: 865-878.
Pakko, Michael R. and
Pollard, Patricia S. “For Here or To Go? Purchasing Power Parity and the Big
Mac.” Federal Reserve Bank of St. Louis Review, January/February 1996, 78(1),
Rogoff, Kenneth. “The
Purchasing Power Parity Puzzle.” Journal of Economic Literature, June 1996,
34(2) pp. 647-68.
Paul A. “Theoretical Notes on Trade Problems.” Review of Economics and
Statistics, May 1964, 46(2), pp. 145-54.
and M. Taylor (2002). “Purchasing Power Parity and the Real Exchange Rate.” IMF
Staff Papers 49: 65-105.
A. and M. P. Taylor (2004). “The Purchasing Power Parity Debate.” Journal of
Economic Perspectives 18: 135-158.
M. (2006). “Real Exchange Rates and Purchasing Power Parity: Mean Reversion in
Economic Thought.” Applied Financial Economics 16: 1-17