Business, Legal & Accounting Glossary
A crude but entertaining analysis, originated by The Economist magazine, comparing the price of the ubiquitous snack, designed to show relative price levels around the world and judge whether a currency might be over or undervalued.
It was introduced by Economist magazine in 1986. It involves the concept of ‘purchasing-power-parity’ in economics. Purchasing power parity (PPP) theory states that ultimately exchange rates between nations should attain a level where an identical consumption basket (comprising goods and services) would display same price in concerned nations. In this particular case, a Big Mac replaces that representative consumption basket. Big Mac PPP is that exchange rate, which makes the price of a hamburger in any country same as that (prevalent) in the USA. Big Mac index enables economists to make exchange rates comparisons and comparisons of relative prices among countries, worldwide. Thus Big Mac Index provides an indication of overvaluation or undervaluation of currencies.
Purchasing power parity ( PPP) theory states that currency exchange rates are at equilibrium when their respective purchasing powers are same (in each of two nations). In case a country’s price level rises due to inflation its exchange rate needs to be depreciated to maintain PPP. Basis of PPP is ‘law of one price’. It states that in the absence of transaction costs including transportation costs, competitive markets tend to equalize the price of a representative and identical commodity in two nations. (However, for this prices need to be expressed in the same currency).
Economists make use of two types of purchasing power parity.
Absolute PPP implies that an identical consumption basket ought to cost the same in any two countries. If there exists any deviation from this equilibrium situation then movements in the exchange rate and relative prices work towards restoring the equilibrium situation.
Relative PPP offers an explanation for inflation rate differential among nations. For instance for maintaining purchasing power parity between countries, a country with a higher inflation rate needs to depreciate its currency vis-a-vis that of its trading partner. PPP theory may fail to deliver due to a host of factors like barriers to trade, pricing to market and inclusion of non-traded things in the cost of a product.
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This glossary post was last updated: 26th April, 2020 | 11 Views.