Purchasing Power Parity 101 – A Beginner’s Guide

Purchasing Power Parity Explained

If you have spent any amount of time with the Big Mac Index, then you have certainly come across the term “Purchasing Power Parity”.  The Economist’s official Big Mac Index page states that the Big Mac Index is “based on the theory of purchasing-power parity (PPP)” but what does that mean?  The short answer is that over the long run, currencies should equalize in value (or tend toward parity) with each other.

So what does this mean in terms of Big Macs and dollars?  Well let’s look at some actual data from the 2013 Big Mac Index … specifically the price of a Big Mac in the United States (U.S. Dollar), China (Chinese Yuan), and Colombia (Colombian Peso).  I’ve chosen these countries because in 2013, China’s currency undervalued according to the dollar, the U.S. dollar has traditionally been the “benchmark” currency in the Big Mac Index, and Colombia’s currency is overvalued slightly according to the dollar.

CountryLocal PricePrice in DollarsPPP of the DollarDollar Exchange RateValuation Against the Dollar
United States4.24.2110
Colombia84004.5420001852.158.05
China15.42.443.676.32-41.9

Let’s say you start with $4.20.  That’s enough to buy a single Big Mac in the United States.  So what happens if we convert that dollar to Chinese Yuan?  We end up with 26.54 yuan which is enough to buy 1.72 Big Macs!  This means that the dollar is a stronger currency.  As a side note, China is notorious for keeping the value of their currency low in order to encourage exports and this is a a mini example of how that makes sense.  Someone in the United States could take their dollars and instead of getting a single Big Mac, buy 1.72 Big Macs just by converting their currency to Yuan.  In effect, export 1.72 Big Macs to the United States because they are cheaper there … put another way, the dollar goes farther there.  The Yuan is undervalued against the dollar by about 42%.

Now let’s take our $4.20 and instead of converting it to Chinese  Yuan, we will convert it to Colombian Pesos.  After the conversion we will have 7779 pesos which is only enough to buy .93 of a Big Mac.  It’s close to a full Big Mac but not quite there which is why the Colombian Peso is overvalued against the dollar but only by about 8%.

How is “Implied PPP of the Dollar” Calculated

In short …

Big Mac Price in Local Currency – Big Mac Price in Dollars = Implied PPP of the Dollar

… or using the data above

8400 Columbian Pesos / $4.20 U.S. Dollars = 2000

15.4 Chinese Yuan / $4.20 U.S. Dollars = 3.67

The longer explanation …

The way the Economist phrases it is a little bit confusing.  For this column in the tables, just think of keeping the price of the Big Mac constant.  It’s like saying, “Since 8400 Colombian Pesos AND $4.20 U.S. Dollars can both buy me a Big Mac, then they should have the same value”.  According to Purchasing Power Parity, the price of a Big Mac SHOULD remain constant in any country based on the current exchange rate.  In other words, your $4.20 once converted to any other currency SHOULD buy you exactly one Big Mac.  In the case of U.S Dollars and Colombian Pesos, that would imply that $4.20 and 8400 Colombian Pesos have the exact same value (assuming as we are that the price of a Big Mac is the value that is held constant).

Why are Implied PPP of the Dollar and Actual Dollar Exchange Rate not the same?

There are actually two answers to this question.  The first is that although the Big Mac makes sense as a substitution for a “basket of goods” it is not a perfect “basket”.  In reality, no basket of goods is perfect.  Maybe China is actually more efficient at producing a Big Mac and Colombia is less efficient thereby necessitating a lower or higher price.

The second reason is that for policy reasons, countries will take actions to either devalue or increase the value of their currencies.  Generally a lower currency value encourages exports and a higher currency value encourages internal consumption (buying).  This topic is far deeper than I intend to cover here but in short, a country can take it’s own currency and buy dollars in order to weaken it’s own currency and strengthen the dollar (or whatever currency they are buying).  Since the dollar has been the world’s reserve currency for quite a while, many countries have bought dollars to store a foreign reserves.  This increases the demand for the dollar and a simple supply and demand calculation shows that this increases the value of the dollar while decreasing the value of the purchasing currency.

Also, as of now the dollar is still used to settle many international monetary transactions which increases demand for the dollar.  When there are more sellers of an item than buyers (even a currency), it’s value goes down.

Summary

I hope that this post helps to explain a little bit more about Purchasing Power Parity and some background on why there are such huge differences in the value of currencies.  Please post below or contact me if you have any questions

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