Bank and Money

Bankand Money

Myarticle of choice is from The Economist journal of 23rdJuly 2016 titled, The Big Mac index, Patty-purchasing parity. Thearticle proposes that it would be easier to compare differenteconomies if they had similar goods. The Big Mac burger becomes thebenchmark of choice for evaluating the different economies. Thewriter chooses it due to its consistency from year to year andcountry to country.

Inchapter ten we learned of purchasing power parity which assumes thata dollar will give you similar service and commodities everywhere.Purchasing power parity works on the assumption that all goods aretrade goods. In actual sense, the value of the dollar and that of aBig Mac is not the same everywhere. The article tries to simplifywhat we learned on foreign exchange using the Big Mac.

Analysis

Thearticle uses the price of a Big Mac to create a Big Mac index forcalculating the strength of different currencies. The index containsthe prices of the burger in 59 countries (TheBig Mac index, 2016).In America, the price of a Big Mac is about $5.04. In Hong Kong, itis $2.50. A possible reason for the price discrepancy is theundervaluation of the Hong Kong currency. The Big Mac Index isasimple way to comparedifferentcurrencies. The burger is the hypothetic alternative for comparingmoney. From a critical standpoint, the exchange rate betweencurrencies would equalize the price of the burger.

Figure1. The Big Mac index (TheBig Mac index, 2016)

Thepossible exchange rate of the Hong Kong dollar to the American dollarcould be 3.81. In reality, the exchange rate is 7.75. The Hong Kongdollar is much weaker. Using our Big Mac index, we can conclude thatthe Hong Kong dollar is less than half of what it should be (TheBig Mac index, 2016).

Asimilar analysis of other currencies against the American dollarreveals that they are very cheap as compared to the dollar. Thecurrencies of developing nations are the cheapest. It is onlySwitzerland, Sweden and Norway that have overvalued currencies. TheBig Mac index implies that the dollar is too expensive which is nottrue. There are fundamental economic reasons which make exchange ratecheaper in developing countries. One of them is low productivity.Developing nations experience reduced productivity in non-tradableand tradable sectors. A non-tradable sector of the economy isthe serviceindustry while an example of a tradable sector is manufacturing. Whenproductivity in manufacturing in emerging markets increases, factoryworkers will be paid more resulting in an upward pressure on pricesand wages in other sectors of the economy. The fast food chains willexperience the upward pressure leading to an increase in the price oftheir Big Macs. The exchange gap will then reduce (TheBig Mac index, 2016).

TheBig Mac index can measure the size of national economies. To do this,we find out how many Big Macs a country can purchase using all of itsannual income. We also apply our economic knowledge on how tocalculate GDP.

TheIMF forecasts that America’s income this year would be $18.5trillion. It can thus purchase 3.7 trillion burgers when each costsabout $5. China’s gross domestic product this year will be about 3trillion yuan which is equivalent to almost $11.4 trillion. In China,the Big Mac costs 18.6 yuan. China’s GDP is 3.9 trillion burgers(TheBig Mac index, 2016).China’s economy is by far smaller that America’s but this is notthe case when we employ patty-purchasing parity to evaluate the two.

Conclusion

Thisarticle, on Patty-purchasing parity, is an application of purchasingpower parity which we learned when tackling the topic of foreignexchange. Despite its simplicity, the article is very factual andmakes the public aware of this important economic principle.Purchasing power parity helps us compare the income levels indifferent countries and understand why a commodity, like the Big Mac,has different prices in different countries.

References

TheBig Mac index Patty-purchasing Parity. (2016, July 23). TheEconomist, 610(1050),n/a.Retrievedfromhttp://www.economist.com/news/finance-and-economics/21702482-size-world-economymeasured-burgers-patty-purchasing-parity