The happenings "inside" the Wisconsin State Treasury and across the street at the State Capitol

The Economy & You #54 – International Purchasing Power and the Big Mac


A central doctrine in economics states that goods should sell for the same price around the world after we adjust for exchange rates between national currencies, and the exchange rate between two countries should mirror the difference in price levels between those two countries.

To test this theory, we need to select a good that is sold in many places throughout the world such as a Big Mac.  The idea is that the difference in price for a Big Mac in the U.S. and the price for a Big Mac in Norway should be approximately the same as the difference in the exchange rate between the U.S. Dollar and the Norwegian Kroner. The higher the price difference should coincide with a higher exchange rate.

In 2008, the magazine The Economist collected such data.  The Big Mac sold for $3.57 in the United States (this is the average price). In the United Kingdom (England) the cost was 2.29 British Pounds. Therefore we would predict that the exchange rate between the dollar and the pound to be 2.29/3.57, or 0.64. At this exchange rate, the Big Mac would cost the same in both the U.S. and in England. The actual exchange rate was 0.50. The Economist collected Big Mac prices and actual exchange rates for 32 countries. Here is a list of 10 countries for a quick comparison.

Country Currency Big   Mac Price Predicted   Exchange Rate Actual   Exchange Rate
United States Dollar 3.57 1.00 1.00
South Korea Won 3,200.00 896.00 1,018.00
Chile Peso 1,550.00 434.00 494.00
Japan Yen 280.00 78.40 106.80
Norway Kroner 40.00 11.20 5.08
Mexico Peso 32.00 8.96 10.20
China Yuan 12.50 3.50 6.83
Brazil Real 7.50 2.10 1.58
Canada Dollar 4.09 1.15 1.00
United Kingdom Pound 2.29 0.64 0.50

The theory of purchasing power parity the U.S. dollar should buy (or be exchanged for) the greatest number of South Korean Won and the fewest British Pounds, and this is the case. The theory also predicts that exchange rate for Canadian dollars to U.S. dollars should be close to the actual exchange rate, and this too turns out to be true. Still, the theory’s predictions are not exact and in many cases are off by 30 percent.  In the case of Norway, the exchange rate between the dollar and the kroner are off by 50%.

In short, the price differences in the cost of a Big Mac can provide a rough estimate as the level of exchange rate between countries, but it does not explain exchange rates completely. Nor would the actual exchange rates be able to provide you with the exact cost of a Big Mac in another country.

Advertisements

Leave a Reply

Please log in using one of these methods to post your comment:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s