The Big Mac Index computed by The Economist magazine has consistently found the U.S. dollar to be undervalued against some curren- cies and overvalued against others. This fi nding seems to call for a rejection of the purchasing power parity theory. Explain why this index may not be a valid test of the theory

The Big Mac Index computed by The Economist magazine has consistently found the U.S. dollar to be undervalued against some currencies and overvalued against others. This finding seems to call for a rejection of the purchasing power parity theory. Explain why this index may not be a valid test of the theory

Case Study 19.1: The Big Mac Index

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As you have already learned, the PPP theory predicts that in the long run the exchange rate between two cur-
rencies should move toward equalizing the cost in each country of an identical basket of internationally traded
goods. A light-hearted test of the theory has been developed by
The Economist
magazine, which compares prices
around the world for a “market basket” consisting simply of one McDonald’s Big Mac—a product that, though not
internationally traded, is essentially the same in more than 100 countries.
The Economist
begins with the price of a
Big Mac in the local currency and then converts that price into dollars based on the exchange rate prevailing at the
time. A comparison of the dollar price of Big Macs across countries offers a crude test of the PPP theory, which predicts that
prices should be
roughly equal in the long run.
This chart lists the
dollar price of a Big Mac in
March 2010, in 22 surveyed
countries plus the euro zone
average. By comparing the
price of a Big Mac in the
United States (shown as
the green bar) with prices
in other countries, we can
derive a crude measure of
whether particular curren-
cies, relative to the dollar,
are overvalued (red bars) or
undervalued (blue bars). For
example, because the price
of a Big Mac in Norway,
at $6.87, was 92 percent
higher than the U.S. price of
$3.58 the Norwegian krone
was the most overvalued
relative to the dollar of the
countries listed. But Big
Macs were cheaper in most
of the countries surveyed.
The cheapest was in China, where $1.83 was 49 percent below the U.S. price. Hence, the Chinese yuan was the most undervalued re
lative to
the dollar.
Thus, Big Mac prices in March 2010 ranged from 92 percent above to 49 percent below the U.S. price. The euro was 29 percent ove
rval-
ued. The price range lends little support to the PPP theory, but that theory relates only to traded goods. The Big Mac is not t
raded internation-
ally. Part of the price of a Big Mac must cover rent, which can vary substantially across countries. Taxes and trade barriers,
such as tariffs and
quotas on beef, may also distort local prices. And wages differ across countries, with a McDonald’s worker averaging about $8 a
n hour in the
United States versus more like $1 an hour in China. So there are understandable reasons why Big Mac prices differ across countr
ies.
SOURCES:
“The Big Mac Index: Exchanging Blows,”
The Economist
, 17 March 2010; David Parsley and Shang-Jin Wei, “In Search of a Euro Effect: Big Lessons from a Big Mac
Meal?”
Journal of International Money and Finance
, 27 (March 2008): 260–276; Ali Kutan et al., “Toward Solving the PPP Puzzle: Evidence from 113 Countries,”
Applied Economics
,
41 (Issue 24, 2009): 3057–3066; and the McDonald’s Corporation international Web site at http://www.mcdonalds.com.
QUESTION
1. The Big Mac Index computed by
The Economist
magazine has consistently found the U.S. dollar to be undervalued against some curren-
cies and overvalued against others. This fi nding seems to call for a rejection of the purchasing power parity theory. Explain w
hy this index
may not be a valid test of the theory.
Case Study 19.2: What About China?
The U.S. trade defi cit with China of $227 billion in 2009 exceeded America’s combined defi cits with the European Union, OPEC co
untries, and
Latin America. The defi cit with China grew about 15 percent annually between 2007 and 2010. Americans spend four times more on
Chinese
products than the Chinese spend on American products. Between 2007 and 2010, China’s holdings of U.S. Treasury securities more
than
doubled from $400 billion to $900 billion.
Many economists, politicians, and union offi cials argue that China manipulates its currency, the yuan, to keep Chinese products
cheaper
abroad and foreign products more expensive at home. This stimulates Chinese exports and discourages imports, thereby boosting C
hinese
production and jobs. At the same time, the average Chinese consumer is poorer because the yuan buys fewer foreign products.
As we have seen, any country that establishes a fi xed exchange rate that undervalues or overvalues the currency must intervene
continu-
ously to maintain that rate. Thus, if the offi cial exchange rate chronically undervalues the Chinese yuan relative to the dolla
r, as appears to be
the case, then Chinese authorities must continuously exchange yuan for dollars in foreign exchange markets. The increased suppl
y of yuan
keeps the yuan down, and the increased demand for dollars keeps the dollar up.
But the charge that China manipulates its currency goes beyond simply depressing the yuan and boosting the dollar. China’s trad
ing part-
ners increasingly feel they are being squeezed out by Chinese producers without gaining access to Chinese markets. China seeks
every trade
advantage, especially for the 125 state-owned enterprises run directly by the central government. For example, China offers som
e domestic
producers tax rebates and subsidies to promote exports, while imposing quotas and tariffs to discourage imports, such as a 25 p
ercent tariff on
auto-parts imports.
China has tried to soothe concerns about the trade defi cit. Most importantly, Chinese authorities in 2005 began allowing the yu
an to rise
modestly against the dollar. As a result, the yuan rose a total of 20 percent against the dollar between July 2005 and July 201
0. China also
announced plans to cut tax rebates paid to its exporters and to lower some import duties. But these measures seemed to have had
little effect
on America’s monster defi cit with China.
Prior to an international fi nance meeting in June 2010, a key European Central Bank offi cial said “the rigidity of the Chinese
monetary
regime had slowed down the recovery in the developed world.” Facing political pressure to do something, China announced that it
would allow
the exchange rate to become more fl exible. We’ll see.
SOURCES:
Lee Branstetter and Nicholas Lardy, “China’s Embrace of Globalization,” NBER Working Paper 12373 (July 2006); Jason Dean and Sh
en Hong, “China Central Bank
Tames Yuan Appreciation Hopes,”
Wall Street Journal
, 22 June 2010; Yujan Zhang, “China Steel Group Accuses U.S. Lawmakers of Protectionism,”
Wall Street Journal
, 5 July 2010;
and Michael Casey, “Showdown Looms Over China’s Currency at G-20,”
Wall Street Journal
, 11 June 2010.
QUESTION
1. Why would China want its own currency to be undervalued relative to the U.S. dollar? How does China maintain an undervalued
currenc