Burgernomics: Exchange Rates and Purchasing Power Parity Analysis Using the Big Mac Index

Especially during the presidential debates in 2012, but even now there has been significant discussion of China's undervalued exchange rate. In class, we have discussed the benefits of having an undervalued exchange rate. The greatest benefit is to domestic exporters, who can sell a lot more products to foreign importers because their prices seem relatively low.  Politicians worry about China's undervalued currency because it gives Chinese exporters an unfair advantage over American manufacturers. A firm is going to buy where the price is lowest, so if a dollar can buy a lot more product from a Chinese producer than an American one, the firm will buy from China. This presents a significant disadvantage for American manufacturing, and therefore should be (and is) a large concern for politicians.

However, an article by the Economist takes a much less alarmist stance on the issue. The article argues that traditional measures actually exaggerate the real value of the yuan, claiming that it is undervalued by around 44% in relation to the dollar. The Economist pegs the value closer to 7%, hardly a cause for alarm,. The Economist uses an amusingly simple system called the Big Mac Index to calculate currency valuations. For a detailed explanation of their newest version of the Big Mac Index, click here. Essentially, the Big Mac Index compares the price of Big Macs around the world with the GDP per capita in each country. The Big Mac Index is theoretically sound because it essentially represents a consumer basket similar to what is use dint he PPP method of exchange rate evalutaion. While Big Macs are not themselves easily traded goods, most of the ingredients that comprise a Big Mac (beef, cheese, sesame seeds, etc) are easily and highly traded goods.

Critics of the Big Mac Index are plentiful. The Balassa-Samuelson Effect claims that you would expect prices to be higher in high-income countries because of labor costs, which are a non-traded good. In the latest article on the topic, the Economist responds to this criticism by first acknowleding that even a seemingly small undervaluation of 7% can have a large impact on economies as large as China. Secondly the Economist says that

"Critics of burgernomics say that you would expect average prices to be cheaper in poor countries than in rich ones because labour costs are lower: PPP signals where exchange rates should head over the long run, as a country like China gets richer, not where prices should be right now. Even so, the perennially undervalued yuan has scarcely moved towards the Big Mac measure of fair value. That, many reckon, is down to meddling by the chefs at the People’s Bank of China, who are relying on export growth for sustenance: China posted a larger-than-expected $36.1 billion trade surplus in December, thanks to 14% growth in exports year-on-year."

While China's currency manipulation is certainly concerning, it is nothing to fight over. More importantly for Europe, the Economist says that the Japanese yen, and even the American dollar and the British pound, have become significantly undervalued in comparision with the euro. If the European Central Bank does not or cannot intervene to slow the appreciation of the euro,  exporters in the Eurozone could see a decrease in revenue in the very near future.