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Playing with and Understanding Purchasing Power Parities.

  • Economics
  • Saturday, 14 Jan, 2023
  • 1611
Playing with and Understanding Purchasing Power Parities

In a PPP scenario, the price of an item in one nation is equivalent to its price in another country after correcting for the difference in exchange rates.

Since 1986, The Economist has used the price of a McDonald's Big Mac burger in various nations as a humorous yearly test of PPP. Let us check out this one-of-a-kind indicator called Big Mac PPP and see what information the price of the ubiquitous Big Mac in a nation may provide about its standard of living.

KEY TAKEAWAYS

  • The Economist conducts a poll called the Big Mac Index to determine whether or not currencies are over- or undervalued based on the price of a Big Mac in different countries.
  • According to the notion of purchasing power parity (PPP), the value of different currencies fluctuates such that the buying power of the people in different nations remains constant.
  • According to the Big Mac PPP survey's assumption, a Big Mac is the same anywhere in the world. Since it utilises a universal supply chain and production process, its relative price should be the same everywhere.

How Purchasing Power Parity (PPP) Works

Assume for the sake of this example that the exchange rate between the U.S. dollar and the Mexican peso is 1 USD = 0.15 MXN. If the U.S. dollar were equal to the Mexican peso, the price of a Big Mac in the U.S. would be $3, while a Big Mac in Mexico would cost around 55 pesos.

Nonetheless, suppose the Mexican price of a Big Mac was closer to 75 pesos. In that case, Mexican fast food store owners could import Big Macs from the United States for $3, at a cost of 55 pesos, and sell them in Mexico for $75, generating a 20-peso risk-free profit. (While this is not likely to happen with hamburgers, the principle applies to other products)

The demand for U.S. Big Macs would push the U.S. Big Mac price to $4, making the arbitrage impossible to exploit for Mexican fast food restaurant operators. PPP would be restored if the price of a Big Mac in the United States was 75 pesos, the same as it is in Mexico.

In addition, PPP ensures that similar products sold in different nations will have comparable pricing (the law of one price).

Currency Value

Given that the Big Mac costs $3.60 in pesos, a PPP exchange rate of US$1 to 20 pesos is inferred. By my calculations, the peso is overvalued by 33% compared to the U.S. dollar, while the USD is undervalued by 25% compared to the PES.

Many Mexican fast-food franchisees selling pesos and purchasing dollars to take advantage of the pricing arbitrage described above would cause the peso's value to fall (depreciate) and the dollar's value to rise (appreciate). Of course, exploiting a single Big Mac would not be enough to affect a country's exchange rate, but in principle, doing it to all products might shift the exchange rate enough to restore price parity.

If the price of products in Mexico is much higher than the price of the same goods in the United States, then consumers in the United States are more likely to purchase goods produced in the United States rather than in Mexico. With less demand, Mexican vendors would have to decrease their prices to compete with those in the United States.

A second option is for the Mexican government to allow the peso to weaken against the dollar, which would mean that consumers in the United States would pay the same amount for Mexican imports as they would for American ones.

Short-Term Versus Long-Term Parity

The empirical data suggests that PPP is not seen in the short run for a wide variety of products and baskets of goods, and its long-term applicability is also debatable. In their study "Burgernomics," Pakko and Pollard discuss why PPP theory does not match reality (2003). The variations are due to factors such as:

Transport Costs: Items that cannot be found locally will have to be sent in, increasing the total price tag. Consequently, the price of imported items will be greater than that of equivalent domestic goods.

Taxes: Goods will sell for a more excellent price in one nation than another if its government sales taxes, such as its value-added tax (VAT), are higher.

Government Intervention: Tariffs imposed at the border on incoming products raise their final prices. By limiting production, they drive up demand and hence prices. A product's price tends to be cheaper in nations where there are fewer regulations and more of it.

If governments choose to impose export restrictions, the price of an item will rise in nations that import it due to scarcity, while it would reduce in countries that export it because of an increase in supply.

Non-Traded Services: The price of a Big Mac includes non-transferable fees for ingredients. As a result, it is very improbable that such expenses would be comparable across countries. Expenses like these might include rent or mortgage payments, insurance premiums, utility bills, and, most importantly, wages.

According to PPP, nations with high costs of non-traded services would have comparatively high goods prices, making their currency overvalued compared to countries with low costs of non-traded services.

Market Competition: Goods may be priced artificially higher in a nation by a corporation that has a monopoly on the market or is a member of a cartel that manipulates pricing to maintain its competitive advantage.

The corporation may get a higher price due to the demand for its well-known brand name. On the contrary, it may take years of supplying items at a discount price in order to create a brand and add a premium, mainly if there are cultural or political challenges to overcome.

Inflation: The inflation rate measures how quickly a country's economical prices rise or fall relative to a baseline. In contrast to the absolute PPP test outlined above, relative PPP does not need the items to be identical.

The Bottom Line

According to PPP, the price of a product expressed in one currency should be comparable to that of any other, given the then-current exchange rate between the two currencies. In practice, this connection typically fails because of other confounding factors. However, certain currencies have been demonstrated to keep their relative PPP over time, even when inflation is included.


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