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Factors Affecting Purchasing Power Parity

Question:

Discuss about the Global Poverty Goals and Prices Rates.

The report is aimed to look into the concept of Purchasing Power Parity, by taking the Big Mac product of McDonald’s and comparing the prices in US Dollars with the currencies of other countries [1].

This concept in Economics says that the rate of exchange between two countries is equal when the purchasing power in both the countries is similar. This is a relative measure to analyze the changes in prices of products, affecting the purchasing power over a period of time.

McDonald’s Big Mac is considered for preparing the report, whereby 10 countries are considered to compare their local currency with the US Dollars and determine the price fluctuations in them. The countries considered for comparison are United States, Brazil, Denmark, China, Australia, Malaysia, Egypt, Russia, Hong Kong and South Korea.

There are certain factors which affect the purchasing power parity. The factors include, prices of the commodities, kind of employment and wages provided to the consumers, currency and credit availability [2].

All these factors impact the purchasing of customers across nations. There are also certain problems, which arise due to the application of this method. These include, the method is based on statistics, related to the way parity computation is done. Only a sample of a commodity is considered, where the real price indices are calculated from that sample, rather than considering all the commodities present in an economy. Another problem is that the theory puts emphasis only on the exchange rate, rather than the income levels of people staying in particular countries.

Purchasing Power Parity, a theory in economics, talks about the fact that when the purchasing power for two countries is same, the rates of exchange between those countries are equal. This theory puts stress on the fact of maintaining one price for products across different regions[3]. Economists believe that once the difference in exchange rates is taken into consideration, then every commodity would cost the same amount. In this report, Big Mac of McDonald’s is considered with the price comparisons of the product done for 10 countries, taking US Dollars as the base[4].

Cost of transportation – When goods get transported by the manufacturer to reach the marketplace, that cost incurred in transportation gets added by the retailer to the final cost of the goods. The farther the goods need to travel from the manufacturer to the market, higher is price charged for those goods from the customers in that region. Hence the purchasing power for customers living in close vicinity is far less as compared to the ones staying far away from the market. Thus the rule of thumb for Purchasing Power Parity, having one price for all, does not hold as price in different markets for the same good is not constant.

Analysis of Big Mac Prices in 10 Countries

Demand – Prices of commodities are set by the manufacturers and they get adjusted according to the demand in specific marketplaces. High demand for the products leads to hike in prices and subsequently when demand falls, prices also come down. In this  situation, the law applied for Purchasing Power Parity does not hold as customers staying in high-demand areas would have low purchasing power due to the high prices charged for the commodities [5].

Similarly people who live in areas with demand on the lower side, possess higher purchasing power because prices for the same products are less expensive.

Taxes – Taxes influence the pricing of goods to a great extent, which leads to the price variations for same product in different market areas. There are areas where sales tax applied, is higher[6]. In those regions, the purchasing power of consumers is less as the final price required to be paid for consuming the commodity is on the higher side. Similarly, the areas where the applicable sales tax is low, the consumers can have a higher purchasing power as the price they are required to pay is low. This differentiation is caused in prices due to the application of sales taxes on them, so the one price law in case of Purchasing Power Parity is no longer applicable.

Prices – The purchasing power of individuals gets directly impacted by inflation. This is the rate through which the general level of prices for goods and other services rise on a continuous basis, resulting in a fall in the purchasing power of currencies[7]. People are not inclined towards buying products by paying high prices, thus giving rise to a fall in demand. This problem can be tackled through increasing the wages, rate of interest and other related factors.

Employment and Wages – Level of employment and average salaries of the consumers in general have a great effect on the purchasing power. The logic behind this comes from the fact that more employment for people will bring more money into the hands of people, which would in turn lead to an increase in purchasing power [8]. Employment does not allow any nation’s currency to get stronger but has an effect on people’s purchasing power by bringing more money into the hands of customers.

Considerations in Currency – Fluctuations in exchange rates affect purchasing power to a great extent. Considering the case of McDonald’s Big Mac, when there is a devaluation of currency against another, goods in the second country would cost higher in first country’s currency. Suppose, the price of Big Mac in Russia is 41 Ruble but in US dollars, the price is 1.32, then the implied PPP of dollar would be very high, around $15.1.

Conclusion

Credit Availability – The willingness of financial institutions like banks to lend money to businesses and consumers affect total purchasing power, just like higher salaries and level of employment do. When credit is available, companies and consumers tend to spend more than the amount they actually possess, thus they get a boost on their purchasing power. This gives rise to more number of products getting bought even in high prices.

The analysis and discussions on the price of Big Mac in local currencies of those regions against US dollars in 10 selected countries are given below, taking the base price in US Dollars, charged for the product in US as $5.04

New Zealand – In New Zealand Dollar, the Big Mac costs NZD $6.94 (market value), whereas the same product, if bought by someone staying in New Zealand after converting to US Dollars, he would have paid USD 6.03, which is far less as compared the amount he is paying in his own currency, which implies that Purchasing Power Parity is 5.80 (implied value). In this case Big Mac should sell for less in New Zealand. [9].

Argentina – In Argentine Peso, a Big Mac would cost ARS $85.52. Whereas, when the Argentines are looking to buy the same product in US Dollars, they would have to pay far lesser amount of only USD 6.47. So, in this case if Peso is considered, the currency is overvalued, as for the same product, they are paying more. In this case, the implied PPP of the dollar is $66.57. Even in this case Big Mac should less in Argentina

Japan – In the currency of Japan, a Big Mac would cost JPY569.82. The Japanese people aiming to buy the product in US Dollars, would have paid only $7.95. The implied Purchasing Power Parity of US Dollar is 361.36. The product should sell for less in New Zealand than in the US.

Switzerland – Now coming to Switzerland, whose currency is Swiss Franc. For a Big Mac purchased in Switzerland, people need to pay, they have to pay 4.86 CHF, whereas when they try to buy that in US Dollars, they would pay only USD 3.96. The implied PPP of US Dollar is 6.18. Big Mac should sell for more in Switzerland.

Saudi Arabia – In Saudi Arabia, a Big Mac costs 18.90. When the currency is converted to US Dollars, only USD 8.35 is paid for the product. So, in that situation, people of Saudi Arabia could pay a lot less and get the same product, with the implied PPP of Dollar being 11.41 [10]. Product would sell for lesser amount in Saudi Arabia.[11].

Colombia – In Colombian Peso, a Big Mac costs 15382.89. When the currency is converted to US Dollars, only USD 8.24 is paid. Then, people of Saudi Arabia would get the same product by paying lot less, with the implied PPP of the dollar being 9414.34. Hence the product would sell for more in Colombia.

Indonesia – In Indonesian Rupaiah, Big Mac costs 67382.28. When the currency is converted to US Dollars, only USD 11.12 is paid. The implied PPP of dollar being 30550.01, thus the product would sell for more in Indonesia.

Hungary – In this case, people of Hungary would have to pay HUF 1353.86 to get a Big Mac from McDonald’s. When the currency gets exchanged with US Dollars, the product would cost US $8.32. The implied Purchasing Power Parity of the Dollar is 819.71. As the implied PPP is less, hence Big Mac should sell for lesser amount in Hungary.

Fiji – Here, people of Fiji would be paying 4.65 Fijian Dollar to get one 1 Big Mac from McDonalds. On the other hand, when the currency gets exchanged with US Dollars, then they would be paying US $0.578. The implied Purchasing Power Parity of dollar is 0.667. As the implied PPC is less, so Big Mac would sell for lesser amount in Fiji.

Cyprus – People of Cyprus would be paying CYP 5.29 to acquire a Big Mac. In US Dollars, they would need to pay only $1.98. Now the implied Purchasing Power Parity is 1.04. In this case, the implied Purchasing Power Parity is less, hence Big Mac would sell for less in Cuprus. This would not be feasible for McDonald’s.


Table to show purchasing power parity of 10 different countries:

                  Big Mac Prices

In local

currency

In US Dollars

Implied PPP of the Dollar

Actual Dollar Exchange Rates as on 1st Oct 2017

Undervaluation/

Overvaluation against US Dollar

United States

   $5.04

5.04

New      Zealand

NZD $6.94

6.03

5.80

1.15

-404%

  Argentina

ARS $85.52

6.47

66.57

13.21

-166%

     Japan

JPY 569.82

7.95

361.36

71.67

-230%

Switzerland

4.86 CHF

3.96

6.18

1.22

-406%

Saudi Arabia

18.90 Saudi Riyal

8.35

11.41

2.26

-404%

Colombia

COP 15382.89

8.24

9414.34

1866.85

Indonesia

67382.28 Indonesian Rupaiah

11.12

30550.01

6059.55

Hungary

HUF 1353.86

8.32

819.71

1.65

Fiji

FJD 4.65

0.578

0.667

2.07

67.77%

Cyprus

CYP 5.29

1.98

1.04

2.67

In United States, a Big Mac costs $5.04, whereas price of the same product in New Zealand is NZD $6.94. Using the dollar exchange rate, the cost in Dollars is $6.03. Calculation – (6.94/6.03) = 1.15. Now, as Big Mac in New Zealand has a price of AS $6.94, so the implied PPP of the dollar is (6.94/5.04) = 1.37. Now through comparison of the implied Purchasing Power Parity exchange rate with the actual exchange rate for the NZD to the US Dollars, this can be inferred that value of NZD is higher by 16.426% in relation to the US Dollars [12].


In Argentina, the value of Big Mac in Argentine Peso is 85.52, whereas the price is US Dollars is $6.47. The implied PPP of the Dollar is 66.57. The actual dollar exchange rate as on 1st October 2017 is 13.21. The currency is undervalued against Dollar by a massive margin of 403%.

Except for Fiji, in most of countries like New Zealand, Argentina, Switzerland Purchasing Power Parity policy is not going to work for Big Mac, hence this policy is not going to work in favour of the company.

So, in most of the countries, the respective currencies are undervalued against Dollar by a fair margin. Purchasing Power Parity doesn’t hold good for Big Mac, though there is a feeling that products can be traded in different currencies across nations through this theory. The prices in different countries get severely affected by tariffs, tax rates, difference in profit margins and differences in other items, which can be traded upon, such as rent.

On a long term basis, exchanged rates do get influenced by relative price levels, rate of interest, preference for foreign over domestic goods and a nation’s productivity level.

Conclusion

The report concludes that though the concept of purchasing power parity helps to analyze the changes in prices of certain products, which affects the purchasing power over a period of time, this concept doesn’t fit in for all the products. Different products have large deviations in level of prices, when exchange rates are applied. In case of Big Mac, this could be noticed that in most of countries, the concept of Purchasing Power Parity doesn’t work when comparison is done by taking a base price.

References

Beckmann, J., 2013. Nonlinear adjustment, purchasing power parity and the role of nominal exchange rates and prices. The North American Journal of Economics and Finance, 24, pp.176-190.

Engel, C., 2013. Exchange rates and interest parity (No. w19336). National Bureau of Economic Research.

Giovannetti, G., 2013. A survey of recent empirical tests of the purchasing power parity hypothesis. PSL Quarterly Review, 45(180).

Giovannetti, G., 2013. A survey of recent empirical tests of the purchasing power parity hypothesis. PSL Quarterly Review, 45(180).

He, H. and Chang, T., 2013. Purchasing power parity in transition countries: Sequential panel selection method. Economic Modelling, 35, pp.604-609.

Jedrzejczyk, M., 2012. Labor productivity parity vs trend of exchange rate. Modern Economy, 3(06), p.780.

Jolliffe, D. and Prydz, E.B., 2015. Global poverty goals and prices: how purchasing power parity matters.

Jolliffe, Dean, and Espen Beer Prydz. "Global poverty goals and prices: how purchasing power parity matters." (2015).

MacDonald, R. and Stein, J.L. eds., 2012. Equilibrium exchange rates (Vol. 69). Springer Science & Business Media.

McKinnon, R.I. and Ohno, K., 2016. 7 Purchasing power parity as a monetary. The Future of the International Monetary System: Change, Coordination of Instability?: Change, Coordination of Instability?, p.42.

Patel, P.J., Patel, N.J. and Patel, A.R., 2014. Factors affecting currency exchange rate, economical formulas and prediction models. International Journal of Application or Innovation in Engineering & Management (IJAIEM), 3(3), pp.53-56.

Ricci, L.A., MILESI?FERRETTI, G.I.A.N. and Lee, J., 2013. Real Exchange Rates and Fundamentals: A Cross?Country Perspective. Journal of Money, Credit and Banking, 45(5), pp.845-865.

Schulmeister, S., 2013. Currency speculation and dollar fluctuations. PSL Quarterly Review, 41(167).

Tsen Wong, H., 2013. Real exchange rate misalignment and economic growth in Malaysia. Journal of Economic Studies, 40(3), pp.298-313.

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[Accessed 22 July 2024].

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