The Purchasing Power Parity Theory of Currency Exchange Rates

© 1999 Dr. P. LeBel

What is the optimal exchange rate? One interpretation is that it is that rate which brings an
economy's overall international payments into balance over time. Since countries do not allow
fully fluctuating exchange rates, and instead rely on managed floating exchange rates around
targeted bands, it is difficult to derive a direct measure to test the theory against actual exchange
rate fluctuations. Short of such direct observation, one can use a proxy measure, which the
English weekly, The Economist, began publishing as the "Big Mac" Currency index a few years
ago. Basically, the Big Mac index is based on the notion that the McDonald's Big Mac hamburger
package has enough ingredients for a basket of goods that can be directly priced in all major
trading economies. By calculating the price of a Big Mac in $U.S. dollars at the official rate of
exchange, and comparing this dollar price against the $U.S. domestic price of the Big Mac, one
has a ratio of the implied purchasing power parity value of a country's currency. If one then
takes the actual exchange rate and then multiplies it by the implied dollar PPP ratio, one has
a measure of the under or overvaluation of a country's currency. If one then takes the actual exchange
rate and multiplies it against the compound value of the under or overvaluation coefficient, one
derives a uniform Big Mac price in all countries, based on the corresponding PPP exchange rate.
Tests on the Big Mac currency index have proven surprisingly robust in predicting future movements
in international currencies, suggesting that short of a more direct test, the Big Mac test works well.

Figure 1

Big Mac Currency Relative Exchange Rates

1.60

1.40

1.20

1.00

0.80

0.60

0.40

0.20

0.00
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Relative Currency Ratio lic

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Table 1
The Big Mac Currency Table
(A/D) (PLC/P$U.S.) (C-D)/D B*(1+E) A/F
A. B. C. D. E. F. G.
Big Mac Official Rate Implied Actual Under(-)/ PPP PPP
Local Price Dollar Price Dollar PPP Exch.Rate Overvaluation Exchange Rate Mac Price
United States 2.56 2.56
Argentina 2.50 2.50 0.98 1.00 -0.02 0.98 2.56
Australia 2.65 1.75 1.04 1.51 -0.31 1.04 2.56
Austria 34.00 2.62 13.28 12.96 0.02 13.28 2.56
Belgium 109.00 2.87 42.58 38.00 0.12 42.58 2.56
Brazil 3.10 2.72 1.21 1.14 0.06 1.21 2.56
Britain 1.84 3.05 0.72 0.60 0.19 0.72 2.56
Canada 2.79 1.90 1.09 1.42 -0.23 1.09 2.56
Chile 1250.00 2.75 488.28 455.00 0.07 488.28 2.56
China 9.90 1.20 3.87 8.28 -0.53 3.87 2.56
Czech Republic 54.00 1.57 21.09 34.40 -0.39 21.09 2.56
Denmark 23.80 3.39 9.30 7.02 0.32 9.30 2.56
France 17.50 2.84 6.84 6.17 0.11 6.84 2.56
Germany 4.95 2.69 1.93 1.84 0.05 1.93 2.56
Hong Kong 10.20 1.32 3.98 7.75 -0.49 3.98 2.56
Hungary 259.00 1.22 101.17 213.00 -0.53 101.17 2.56
Indonesia 9900.00 1.16 3867.19 8500.00 -0.55 3867.19 2.56
Israel 12.50 3.38 4.88 3.70 0.32 4.88 2.56
Italy 4500.00 2.47 1757.81 1818.00 -0.03 1757.81 2.56
Japan 280.00 2.08 109.38 135.00 -0.19 109.37 2.56
Malaysia 4.30 1.16 1.68 3.72 -0.55 1.68 2.56
Mexico 17.90 2.10 6.99 8.54 -0.18 6.99 2.56
Netherlands 5.45 2.63 2.13 2.07 0.03 2.13 2.56
New Zeand 3.45 1.90 1.35 1.82 -0.26 1.35 2.56
Poland 5.30 1.53 2.07 3.46 -0.40 2.07 2.56
Russia 12000.00 2.00 4687.50 5999.00 -0.22 4687.50 2.56
Singapore 3.00 1.85 1.17 1.62 -0.28 1.17 2.56
South Africa 8.00 1.59 3.13 5.04 -0.38 3.13 2.56
South Korea 2600.00 1.76 1015.63 1474.00 -0.31 1015.63 2.56
Spain 375.00 2.40 146.48 156.00 -0.06 146.48 2.56
Sweden 24.00 3.00 9.38 8.00 0.17 9.38 2.56
Switzerland 5.90 3.87 2.30 1.52 0.52 2.30 2.56
Taiwan 68.00 2.06 26.56 33.00 -0.20 26.56 2.56
Thailand 52.00 1.30 20.31 40.00 -0.49 20.31 2.56

Relative D. 1.52
Actual F. 2.30
PPP E. 0.52
Under(-)/ G.
PPP BigA.
Mac C.2.30
Implied B. Price
PPP Official Rate
United Israel Currency
States
Switzerland
Denmark
Britain
Sweden
Belgium
France
1.52
1.32
1.19
1.17
1.12
1.11
Ratio Currency
1.00
0.66
0.76
0.84
0.85
0.89
0.90
Ratio Exch.Rate
7.02Exchange
1.00
3.70
0.60
8.00
38.00
6.17
Rate Overvaluation
1.00
9.30
4.88
0.72
9.38
42.58
6.84 0.32
0.19
0.17
0.12
0.11
Mac Price
2.56
2.56
2.56
Local Price
2.56
5.90
23.80
12.50
1.84
24.00
109.00
17.50
Dollar 9.30
4.88
0.72
9.38
42.58
6.84
Dollar 2.56
3.87
3.39
3.38
3.05
3.00
2.87
2.84
Chile
Brazil
Germany
Netherlands
Austria 1.07
1.06
1.05
1.03
1.02 0.93
0.94
0.95
0.97
0.98 455.00
1.14
1.84
2.07
12.96 488.28
1.21
1.93
2.13
13.28 0.07
0.06
0.05
0.03
0.02 2.56
2.56 1250.00
3.10
4.95
5.45
34.00 488.28
1.21
1.93
2.13
13.28 2.75
2.72
2.69
2.63
2.62
Argentina
Italy
Spain
Mexico
Japan 0.98
0.97
0.94
0.82
0.81 1.02
1.03
1.06
1.22
1.23 1.00
1818.00
156.00
8.54
135.00 0.98
1757.81
146.48
6.99
109.37 -0.02
-0.03
-0.06
-0.18
-0.19 2.56
2.56 2.50
4500.00
375.00
17.90
280.00 0.98
1757.81
146.48
6.99
109.38 2.50
2.47
2.40
2.10
2.08
NewTaiwan
Russia
Canada
Zeand
Singapore 0.80
0.78
0.77
0.74
0.72 1.24
1.28
1.30
1.35
1.38 33.00
5999.00
1.42
1.82
1.62 26.56
4687.50
1.09
1.35
1.17 -0.20
-0.22
-0.23
-0.26
-0.28 2.56
2.56
2.56 68.00
12000.00
2.79
3.45
3.00 26.56
4687.50
1.09
1.35
1.17 2.06
2.00
1.90
1.85
South
South
zech Korea
Australia
Africa
Republic
Poland 0.69
0.62
0.61
0.60 1.45
1.46
1.61
1.63
1.67 1474.00
1.51
5.04
34.40
3.46 1015.63
1.04
3.13
21.09
2.07 -0.31
-0.38
-0.39
-0.40 2.56
2.56 2600.00
2.65
8.00
54.00
5.30 1015.63
1.04
3.13
21.09
2.07 1.76
1.75
1.59
1.57
1.53
Hong Kong
Thailand
Hungary
China
Indonesia 0.51
0.47
0.45 1.95
1.97
2.11
2.14
2.20 7.75
40.00
213.00
8.28
8500.00 3.98
20.31
101.17
3.87
3867.19 -0.49
-0.53
-0.55 2.56
2.56 10.20
52.00
259.00
9.90
9900.00 3.98
20.31
101.17
3.87
3867.19 1.32
1.30
1.22
1.20
1.16
Malaysia 2.21 3.72 1.68 4.30 1.68

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