The Hamburger Standard When economists apply the theory of purchasing-power parity to explain exchange rates, they need data on the prices of a basket of goods available in different countries. One analysis of this sort is conducted by The Economist, an international news magazine. The magazine occasionally collects data on a basket of goods consisting of "two all-beef patties, special sauce, lettuce, cheese, pickles, onions, on a sesame seed bun." It's called the "Big Mac" and is sold by McDonald's around the world. Once we have the prices of Big Macs in two countries denominated in the local currencies, we can compute the exchange rate predicted by the theory of purchasing-power parity. The predicted exchange rate is the one that makes the cost of the Big Mac the same in the two countries. For instance, if the price of a Big Mac is $3 in the United States and 300 yen in Japan, purchasing-power parity would predict an exchange rate of 100 yen per dollar. How well does purchasing-power parity work when applied using Big Mac prices? Here are some examples from July 2009, when the price of a Big Mac was $3.57 in the United States: Price of a Big Mac Predicted Exchange Rate Actual Exchange Rate Country Indonesia 20,900 rupiah 5,854 rupiah's South Korea 3,400 won 952 won/S 320 yen 89.6 yen/s Japan Sweden 39 krona 10.9 krona/$ 7.9 krona/s Mexico 33 pesos 9.2 pesos/$ Euro area 0.93 euros/$ 3.31 euros 2.29 pounds 13.8 pesos/$ 0.72 euros/$ 0.62 pound's Britain 0.64 pound/S You can see that the predicted and actual exchange rates are not exactly the same. After all, international arbitrage in Big Macs is not easy. Yet the two exchange rates are usually in the same ballpark. Purchasing-power parity is not a precise theory of exchange rates, but it often provides a reasonable first approximation. Discuss what is purchasing-power parity. Over the past twenty years, Mexico has had high inflation, and Japan has had low inflation. What do you predict has happened to the number of Mexican pesos a person can buy with a Japanese yen? Do any other factors affect exchange rate? 10,200 rupiah/S 1315 won/S 92.6 yen/s
