Glamor Economics

Chapter 122

Chapter 16 Section 2 Exchange Rate Determines Purchasing Power—Purchasing Power Parity Theory
In September 1986, the famous British magazine "The Economist" launched an interesting "Big Mac Index".The Big Mac Index is an informal economic index, which is used to measure whether the exchange rate of two currencies is theoretically reasonable under the premise that the purchasing power parity theory is established.Assuming that a Big Mac costs $9 in the US and £4 in the UK, economists consider the PPP exchange rate between the dollar and the pound to be £3:$3.If the price of a McDonald's Big Mac in the United States is 4 dollars, in the United Kingdom it is 2.54 pounds, in the euro area it is 1.99 euros, and in China it only costs 2.54 yuan, then economists infer from this that the renminbi is the most undervalued currency in the world most currencies.Because according to the law of one price, the same commodity should have the same price all over the world.If the Big Mac index is greater than 9.9, it means that the price of McDonald's in this country is lower than that of the United States, and vice versa.From the perspective of the exchange rate, it means that the exchange rate of the country's currency is undervalued, or the exchange rate of the US dollar is overvalued.

The price of the same product in currencies around the world varies greatly, and is completely inconsistent with the official exchange rate conversion. Therefore, in the eyes of some Western economists, McDonald's Big Mac has become an index for evaluating the true value of a currency.

The Big Mac Index has given rise to the term "hamburger economy" in English-speaking countries. After 1986, "The Economist" published a new Big Mac Index every year, and this index became popular all over the world.

The Big Mac Index can reflect the purchasing power of different currencies.From a perspective, it can also reflect the exchange rate between different currencies.The Swedish economist Kassel was the first to systematically point out the relationship between exchange rate and currency purchasing power.

In 1916, the Swedish economist Kassel systematically proposed on the basis of summarizing the previous academic theories: the exchange rate of the two currencies is mainly determined by the purchasing power of the two currencies.This theory is called purchasing power parity.

Purchasing power parity theory holds that people demand foreign currency because they can buy foreign goods and services with it, and foreigners need their own currency because they can use it to buy domestic goods and services.Therefore, the exchange of domestic currency for foreign currency is equivalent to the exchange of domestic and foreign purchasing power.Therefore, the price of a foreign currency expressed in domestic currency (that is, the exchange rate) is determined by the ratio of the purchasing power of the two currencies.This is the theory of purchasing power parity.

Purchasing power parity theory believes that there is a single price law in an open economy, which makes the prices of goods in all countries in the world tend to be consistent.Ideally, regardless of whether it is 1 yuan, 1 dollar or 1 euro, they must buy the same amount of goods in all countries, and their actual prices must also be the same.If 1 kilogram of black rice sells for 21 yuan in China and 7 dollars in the United States, then the nominal exchange rate between China and the United States should be 3 yuan to 1 dollar.

Purchasing power parity determines the long-term trend of exchange rates.Regardless of the various short-term factors that affect exchange rate fluctuations in the short term, in the long run, the trend of the exchange rate is basically consistent with the trend of purchasing power parity.Therefore, purchasing power parity provides a better method for forecasting long-term exchange rate trends.

The premise of purchasing power parity is that the exchange rates of two currencies will naturally adjust to the same level, so that the same goods will be sold at the same price in the two currencies (the law of one price).In the Big Mac index, the item is a Big Mac hamburger sold in McDonald's fast food restaurants.The reason for choosing the Big Mac is that the Big Mac is available in many countries, and its production specifications are the same everywhere, and the local McDonald's distributors are responsible for negotiating prices for the materials.These factors allow the index to more accurately compare national currencies.

The purchasing power parity exchange rate for Big Macs between the two countries is calculated by dividing the local price of Big Macs in one country by the local price of Big Macs in the other country.The quotient is used to compare with the actual exchange rate: if the quotient is lower than the exchange rate, it means that the exchange rate of the first country's currency is undervalued (according to the theory of purchasing power parity); conversely, if the quotient is higher than the exchange rate, the first country's currency exchange rate is overvalued.

Economists dispute the scientificity of using a McDonald's Big Mac to measure the purchasing power of each country's currency.Because this measurement method assumes that the theory of purchasing power parity is established, but there is no unified conclusion on whether the theory of purchasing power evaluation is established.

[links to related words]

The law of one price The law of one price can be simply expressed as: When trade is open and transaction costs are zero, the same goods will have the same price no matter where they are sold.For example, when US$1 = RMB 8.2, a commodity that sells for US$ 1 in the United States should sell for RMB 8.2 in China.In this example, whether the commodity is overvalued or undervalued in China or the United States, it will cause the movement of the commodity in the two markets until the prices in the two markets are exactly the same.This reveals a fundamental link between domestic commodity prices and exchange rates.

The theory of interest parity means that in the process of capital circulation, capital should have the same value in different countries, and the price after exchange rate conversion should be the same in all countries. If there is a price difference between countries, international capital trade will occur until this The price difference is eliminated, trade stops, and the equilibrium state of the capital market is reached at this time.Although the equilibrium state it describes is difficult to achieve in the current economic environment, economic development follows this law.

Currency purchasing power refers to the ability of a unit of currency to purchase goods or exchange for services.Its size is determined by the comparative relationship between the value of money and the value of goods; its changes are inversely proportional to changes in commodity prices and service fee levels, and directly proportional to changes in currency values.Under the condition of constant currency value, when commodity prices and service charges decrease, the purchasing power of unit currency will increase; otherwise, it will decrease.

(End of this chapter)