For Here or to Go? Purchasing Power Parity and the Big Mac
Pakko, Michael R., Pollard, Patricia S., Federal Reserve Bank of St. Louis Review
The theory of Purchasing Power Parity (PPP) has a long and venerable tradition in international economics. Fundamentally, the theory states that prices of identical goods in different countries should be equal after adjusting for the rate of exchange between currencies. As a theoretical proposition, PPP serves as a solid foundation for thinking about the conditions under which prices in international markets adjust to attain long-term equilibrium. As an empirical matter, however, PPP has been a more elusive concept.(2)
The Economist has established another, though somewhat more recent, tradition: the Big Mac standard. Since 1986, The Economist has published yearly tongue-in-cheek comparisons of the prices of McDonald's Big Mac sandwich in various countries around the world, evaluating prevailing exchange rates on the basis of these price differentials. A similar index has also been developed by the Union Bank of Switzerland in its annual comparison of prices and incomes around the globe. These light-hearted studies of international hamburger prices have predictably whet the appetites of the popular media and the financial press 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 shaded insert, "A Big Mac Is a Big Mac Is a Big Mac?") For that reason, the Big Mac serves as a convenient market basket of goods with which the purchasing power of different currencies can be compared.
Just as is the case with broader measures, however, the Big Mac standard 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 shed some light on the value of the Big Mac sandwich as a palatable measure of PPP.
THE LAW OF ONE PRICE AND PURCHASING POWER PARITY
A strong version of the purchasing power parity 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 the price of any particular good that is traded on world markets will be the same price in every country engaged in trade.
For instance, consider the price of sesame seeds - one of the basic ingredients of the Big Mac - in Britain and the United States. Letting [Mathematical Expression Omitted] and [Mathematical Expression Omitted] 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) [Mathematical Expression Omitted],
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 [pounds]3. If sesame seeds sold for a price higher than [pounds]3, 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 Purchasing Power Parity
The law of one price generalizes to PPP under special circumstances. Consider price indexes (consumer price indexes, for example) for the United States and Britain, which are constructed by combining the prices of several different commodities. Typically, these indexes are weighted averages of the individual prices. If the same goods are included in each index and if the price indexes are constructed identically, then the overall price levels [P. …