This week, we are going to explore the concepts of the law of one price and the theory of purchasing power parity. In brief, these tell us that in the absence of trade barriers, the same product should cost the same in all countries (the law of one price). However, there are transaction costs and not all products can be traded internationally. These make the law of one price less useful in practice than it is in theoryâ€”at least for many products.
The theory of purchasing power parity, on the other hand, does not have the limitations that the law of one price does. Purchasing power parity tells us that the same product should take the same amount of purchasing power to buy, regardless of the country and currency involved. This approach is useful for international comparisons of numerous economic variables.
This week, we are going to use it to look at currency exchange rates again. Think back to the currency you compared to the US dollar earlier in the course. Now we are going to ask the question: is that currency overvalued or undervalued?
That is actually a rather challenging question to answer. But The Economist has provided us with a rather interesting and quick way of reaching a surprisingly accurate answer to that question. The method is the Big Mac Index.
Following are links to an informative video, a more recent article with Big Mac Index values, and an interactive currency comparison tool. The last two are from The Economist.
Read the 2014 Big Mac Index article: “The Big Mac Index.”
You will probably also want to use the interactive comparison tool: Global Exchange Rates, To Go
Questions to address
- Is the currency of the country you studied previously overvalued or undervalued relative to the US Dollar?
- What does your finding suggest for the future behavior of your selected currency: Is it likely to appreciate or depreciate?
Share your findings with the class.