Do the market exchange rates for different currencies reflect the actual relative values of those currencies?
This question is the basis for analysing purchasing power parity, which tries to measure relative purchasing power, or the amount of goods and services that can be bought in different countries for the same amount of currency traded at market exchange rates.
A classic illustration of this concept is The Economist’s famous Big Mac Index. This compares the prices of a Big Mac in different countries using market exchange rates. By the Big Mac Index, the yen is undervalued about 36%, since a Big Mac costs the market exchange equivalent of $US2.97, compared to the U.S. baseline of $US4.62.
The Council on Foreign Relations, however, thinks the Big Mac is not the right product to use to measure differences in purchasing power.
The reason The Economist uses the price of a Big Mac is that it is a ubiquitous and uniform item. There are McDonalds restaurants all around the world, and a Big Mac in Beijing is about the same as a Big Mac in Brooklyn.
The Council on Foreign Relations, however, noticed a very important problem with using Big Macs in this way: they are not generally purchased by consumers and then moved across country lines. It would make very little sense for an American to take a flight to Hungary to take advantage of the 17% discount on a cheeseburger.
So, CFR constructed a similar ranking, based on a common and uniform item that people could reasonably take overseas: the iPad Mini. Their reasoning is that the iPad is a product that can be more realistically viewed as being bought and sold in a truly global marketplace.
Even though a Big Mac is the same everywhere, eating dinner out has a fundamentally local element to it.
On the other hand, an incredibly popular piece of consumer electronics like the iPad Mini is free from that local factor, and thus might be a better proxy for globalized commerce in general.
Here’s the CFR’s most recent iPad Mini index:
And here’s The Economist’s Big Mac Index:
The biggest difference by far between the two charts is that the price deviations are much smaller for the iPad index than for the Big Mac index, as we would expect from the different nature of the two goods.
As CFR points out, a lot of European countries are somewhat overvalued relative to the dollar by the iPad Mini metric. Meanwhile, China, where the valuation of the yuan is a frequent subject of debate in the U.S., is fairly close to being properly valued.
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