Academic journal article Federal Reserve Bank of St. Louis Review

Burgernomics: A Big Mac[TM] Guide to Purchasing Power Parity

Academic journal article Federal Reserve Bank of St. Louis Review

Burgernomics: A Big Mac[TM] Guide to Purchasing Power Parity

Article excerpt

One of the foundations of international economics is the theory of purchasing power parity (PPP), which states that price levels in any two countries should be identical after converting prices into a common currency. As a theoretical proposition, PPP has long served as the basis for theories of international price determination and the conditions under which international markets adjust to attain long-term equilibrium. As an empirical matter, however, PPP has been a more elusive concept.

Applications and empirical tests of PPP often refer to a broad "market basket" of goods that is intended to be representative of consumer spending patterns. For example, a data set known as the Penn World Tables (PWT) constructs measures of PPP for countries around the world using benchmark surveys that include hundreds of individual items that encompass all of the expenditure components of a nation's gross domestic product.

Many of the principles and limitations of the theory of PPP can be illustrated using a less comprehensive collection of goods. Since 1986, The Economist has published an annual tongue-in-cheek comparison of the prices of the McDonald's Big Mac[TM] sandwich in various countries around the world, evaluating prevailing exchange rates on the basis of international price differences. (1) A similar index has also been developed by the financial firm UBS, as part of a general comparison of prices and incomes around the globe. (2) These lighthearted studies of international hamburger prices have predictably been popular examples of the principles of PPP and have even given serious scholars food for thought. (3)

The attractive feature of the Big Mac as an indicator of PPP is its uniform composition. With few exceptions, the component ingredients of the Big Mac are the same everywhere around the globe. (See the boxed insert, "Two All Chicken Patties?") For that reason, the Big Mac serves as a convenient market basket of goods through which the purchasing power of different currencies can be compared. As with broader measures, however, the Big Mac standard often fails to meet the demanding tests of PPP. In this article, we review the fundamental theory of PPP and describe some of the reasons why it might not be expected to hold as a practical matter. Throughout, we use the Big Mac data as an illustrative example. In the process, we also demonstrate the value of the Big Mac sandwich as a palatable measure of PPP.

THE LAW OF ONE PRICE AND PPP

A strong version of the PPP theory has as its foundation the law of one price. Abstracting from complicating factors such as transportation costs, taxes, and tariffs, the law of one price states that any good that is traded on world markets will sell for the same price in every country engaged in trade, when prices are expressed in a common currency.

For instance, consider the price of sesame seeds--one of the basic ingredients of the Big Mac--in Britain and the United States. Letting [p.sup.[pounds sterling].sub.ss] and [p.sup.$.sub.ss] represent the prices of sesame seeds in Britain (in pounds) and the United States (in dollars), respectively, then the law of one price can be expressed as follows:

(1) [p.sup.[pounds sterling].sup.ss] = e x [p.sup.$.sup.ss],

where e is the pound/dollar exchange rate. If sesame seeds cost $6 per bushel in the United States and the pound/dollar exchange rate is 0.5, then the law of one price states that the price of sesame seeds in Britain should be 3 [pounds sterling]. If sesame seeds sold for a price higher than 3 [pounds sterling], an astute trader could buy sesame seeds in the United States and sell them in Britain at a profit. This type of activity--known as arbitrage--would tend to drive the price of sesame seeds higher in the United States and lower in Britain, with the process continuing until the law of one price prevailed.

Absolute PPP

The law of one price generalizes to PPP under special circumstances. …

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