Case Study 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 newsmagazine. 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 $2 in the United States and 200 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 an Economist article published on April 3, 1999, when the price of a Big Mac was $2.43 in the United States:

Country

Price of a Big Mac

Predicted Exchange Rate

Actual Exchange Rate

Italy

4,500 lira

1,852 lira/$

1,799 lira/$

Japan

294 yen

121 yen/$

120 yen/$

Russia

33.5 rubles

13.8 rubles/$

24.7 rubles/$

Germany

4.95 marks

2.04 marks/$

1.82 marks/$

Brazil

2.95 reals

1.21 reals/$

1.73 reals/$

Britain

1.90 pounds

0.78 pound/$

0.62 pound/$

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

In the United States the price of a Big Mac is $2.43; in Japan it is 294 yen.

I a precise theory of exchange rates, but it often provides a reasonable first approximation.

I QUICK QUIZ: Over the past 20 years, Spain has had high inflation, and Japan has had low inflation. What do you predict has happened to the number of Spanish pesetas a person can buy with a Japanese yen?

The purpose of this chapter has been to develop some basic concepts that macro-economists use to study open economies. You should now understand why a nation's net exports must equal its net foreign investment, and why national saving must equal domestic investment plus net foreign investment. You should also understand the meaning of the nominal and real exchange rates, as well as the implications and limitations of purchasing-power parity as a theory of how exchange rates are determined.

The macroeconomic variables defined here offer a starting point for analyzing an open economy's interactions with the rest of the world. In the next chapter we develop a model that can explain what determines these variables. We can then discuss how various events and policies affect a country's trade balance and the rate at which nations make exchanges in world markets.

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