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Purchasing power parity is an economic concept which measures relative value of different currencies. It shows how much adjustment is required to the exchange rate in order that both currencies can buy the same basket of goods and services in two different countries. PPP basically states that in the long run, prices of identical goods should be equal or at least converging after accounting for exchange rate. PPP is based on the law of one price which states that any item which is traded on the world market should have an equal price in every country.
One of the most universally recognized and used method of comparing PPP is the BigMac Index. Popularized by the economist, the BigMac Index compares the prices of a McDonalds BigMac burger in different countries by converting the prices in a common currency usually the US dollar. All the ingredients contained in the BigMac are traded on the world market like beef, sesame seeds and bread so law of one price should hold for the BigMac. Furthermore, McDonalds serves BigMac in 80 different countries (Citrius 1995) and since the franchise strictly controls the input prices of the ingredients, the price of the BigMac should exhibit equal or at least converging prices. Law of one price makes sense because if there were difference in price levels, a clever buyer would purchase a particular good from the cheapest country and sell in the country which offers the highest price. This type of activity, known as arbitrage, will lead to converging price levels in the two countries until the law of one price prevails.
The formula for calculation of BigMac Index is:
(PA / PUS )(1 / e*) x 100
PA : Price of BigMac in local currency PUS : Price of BigMac in the US e*: exchange rate (amount of local currency required to buy 1 US dollar)
The value of the BigMac index for the base country is 100 and if the BigMac index is above 100 for a particular country it suggests that the country is more expensive than the US and vice versa for a country having an index value below 100. This means that according to the theory of Law of one price a country having an index value above 100 will experience depreciation in the local currency as the local currency was initially overvalued and vice versa for the case where value of the BigMac index is below 100. Furthermore, it is a comprehensive measure of PPP as it includes factor of inputs which are particular to each country such as cost of labor, power, rent and capital. Now let’s have a look at the values of the BigMac index for some countries as illustrated in Figure 1 below:
http://media.economist.com/sites/default/files/imagecache/full-width/images/2012/07/blogs/graphic-detail/20120728_woc694.png Figure 1
Figure 1 shows the BigMac index of different countries for 2007 and 2012. An overvaluation of 20% means an index value of 120 while an undervaluation of 20% means an index value of 80. According to the law of one price the markers should be placed close to the red line in the middle or at least should move towards the red line from 2007 to 2012. This is the case for more than half of the countries but the biggest exception is Venezuela, and Switzerland’s currency moves in the right direction but only marginally. The argument that China’s currency is undervalued is bolstered by the index even though it moves towards parity from 2007 to 2012.
Why does the law of one price fail??
According to Pakko and Pollard (1996) there are six general reasons as to why law of one price might not be true. First of all there are barriers to trade such as tariffs which increase the price of imports and the increased cost is passed onto the consumers. Tariffs are common for agricultural goods as most of the countries try to protect its agricultural sector. Cassel (1921) noted 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. He noted, however, that import restrictions have the opposite effect. Thus, given two countries, the one with the greater restrictions on imports will see its currency overvalued on a PPP basis. Trade barriers may partly explain why the Korean currency has been consistently overvalued relative to the dollar on a PPP basis.” Secondly, transportation costs create a wedge between PPP, especially perishable items which are used to make a BigMac. Thirdly, the price used in the BigMac index is inclusive of tax, and hence a higher VAT or sales tax will result in a higher value in the index.
Pakko and Pollard (1996) continues to explain the influence of non-traded goods on the price of a BigMac. Non-traded goods include real estate and labor, no matter how much the difference in price of these factors of inputs these cannot be imported. For example, when McDonald’s opened in China in 1992, the average monthly pay for a full-time starting worker was $60.12 a full-time starting worker at a McDonald’s in the United States would earn a minimum of $737 a month. This leads to undervalued currency for the low income countries. Pakko and Pollard 1996 show that there exist a strong positive correlation between average earnings relative to US and price of BigMac in US dollars. Then fifthly, market structure may vary from country to country. The price elasticity of demand is inelastic in less developed economies due to fewer substitutes and prices charged are higher in order to maximize revenue and profits. So in general, the greater the imperfections in the market (lesser substitutes), the higher will be the price of the BigMac, hence higher the index value. Sixth, PPP assumes exchange rate determination is based only on goods and services only, however capital flows have an equal if not greater role to play as well. Generally, a country with a higher trade deficit than US will have overvalued currencies but this relationship is not strong.
There are some advanced versions of the BigMac index such as an index which measures how much time on average does it take to earn a BigMac in different countries. This is a better measure of PPP as it takes into account local wages.
The Economist 
Then we have the Tall Latte Index which is similar to the BigMac index and the only difference is it uses the price of a Starbucks tall latte coffee to compare PPP across countries. Starbucks does not operate in as many countries as McDonalds so BigMac Index includes more countries.
The Starbucks tall latte index and the BigMac index are highly correlated for anywhere except Asia where huge differences are seen. Tall latte index claims the Chinese currency is almost on par with PPP contradicting the BigMac index.
Now let’s compare the BigMac index to the Penn World Table. Pakko and Pollard (1996) says PWT (Penn World Table) presents price measures that are based on a common market basket of approximately 150 detailed categories of goods. However, surprisingly as stated in Pakko and Pollard (1996) there is a strong correlation between the two indices of 0.85. Canada is the only out of the 15 countries which differs on the subject whether it is overvalued or undervalued and still the difference is only 14 %.
Indicators of PPP (1991)
Penn World Table
In conclusion, the BigMac index offers a very comprehensive comparison of PPP as it includes both traded and non-traded goods. The concept of PPP is so theoretical that no index observes it and divergences are due to the reality of the world we live in. Since the BigMac Index has strong correlation with both Penn World Table and Starbucks tall-latte index, it is quite accurate. The Penn World Table is more accurate as it includes 150 different goods but then it is more complicated to calculate and the results are similar. BigMac Index can be calculated for many countries unlike other indices. BigMac is the a good measure of PPP, maybe the best but due to the fact that PPP is only observed in very limited circumstances as Pakko and Pollard (1996) says that only 6.5 percent data show deviations of 5 percent or less from PPP, and only 15.5 percent of the observations show deviations of 10 percent or less in the Big Mac Index from 1986-95.
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