In the real world, there is always something between you and what you want. It is called price. Whether we do it rationally, consciously or simply without knowing, we always make our decisions taking prices into account.
Economists came up with the notion of the Law of One Price. Based on a set of unrealistic assumptions (for example, a riskless world), it suggests that identical goods should be priced the same everywhere. If not, there would be arbitrage opportunities which would be exhausted until prices reach equilibrium.
Well, but our world is not exactly as Economists wished for it to be. In reality, prices vary across countries and currencies. If in Portugal you may do something with 1€, you should not expect to do the same, for example, in Norway. The Purchasing-Power Parity Theory (PPP) states that global exchange rates should eventually through a time-consuming adjustment process make the price of identical baskets of tradable goods the same in each country. In reality, it is possible to move tradable goods from one place to the other, influencing prices and implicitly influencing the exchange rate.
When it comes to exchange rates, for simplicity, we can consider two types: the nominal exchange rate (determined by supply and demand) and the real exchange rate. The latter is a real variable, meaning it must be determined by real factors such as productivity and preferences. Real exchange gaps may persist for long periods of time, as long as corresponding gaps are financed by capital flows, but the threat of capital flow reversals may call for fast corrections.
In 1986, “The Economist” constructed the Big Mac Index – aimed to assess whether currencies are correctly priced by comparing the implicit exchange rate given by the prices of the burgers in any two countries and the exchange rate of the market. Surprisingly, the reasons behind choosing the Big Mac have nothing to do with hunger. You can basically walk into any McDonald’s in any country and get essentially the same good (characteristics-wise). The problem with this approach is that the price of a Big Mac also reflects labor and rent costs and taxation that differ greatly across countries and influence the final price. In this sense, the raw Big Mac index can only be considered an approximation and has to be used with caution, in order not to extrapolate wrong conclusions.
Using actual data from ‘The Economist’, we put our hands to work in order to assess the potential of such an exquisite economic index. We selected 7 relevant currencies (used the most important currency – USDollar – as our base), studied a 14y time-span and got something close to this:
For instance, regarding volatility, the raw Big Mac index clearly points to Argentinian Pesos. In this country, the great volatility can be explained by factors such as a low stagnant level of reserves and inflationary expectations that lead to a high degree of uncertainty among individuals. Consequently, foreign investors will perceive the country as less attractive, further depressing the economy into a recessive spiral.
Considering now our Euro experience, the index shows evidence of increasing appreciation against the USDollar until 2008 – after, the movement has precisely been the opposite. With the tremendous negative shock in 2008, European countries became less attractive to foreign investors who reduced their demand for their assets. Consequently, the price of these assets decreased, depreciating the exchange rate.
Moreover, it was fun to see what the raw Big Mac index tells us about the Chinese RMB. Before 2006, the Yuan did not change relative to the US Dollar as it was pegged to it, on a fixed exchange rate regime. However, after 2006, a floating regime was announced and the currency remained highly undervalued, a debate that is still ongoing. It naturally is a source of friction in the US by undercutting US goods that lose out to a cheap Chinese currency. As China’s economic growth is highly dependent on exports, the government wishes to keep the currency undervalued, boosting the trade balance. To keep the currency undervalued, the Chinese Central Bank demands large quantities of dollar assets driving its price up when compared to the Chinese currency. Also, the biggest average appreciation against the USDollar was exactly in 2008. After that dark year, the USDollar started regaining its value continuously.
In the graph below, it is possible to visualize what the raw Big Mac index suggests about: the unstable currency of Argentina; the deliberately undervalued Chinese Yuan; the new experiment of the Euro Area; and the always-been-strong Swiss currency.
690 and 697