Question

Suppose that 0.91 Swiss francs trade for $1, in the U.S. a Big Mac costs $4.37, and in Switzerland price a Big Mac costs 6.5 francs.

(a) What is the value of the real exchange rate between the Swiss and the U.S. Big Mac?

(b) Explain what the theory of purchasing-power parity implies.

(c) If PPP held, what should be the nominal exchange rate between the Swiss franc and the US dollar?

(d) Why is PPP not entirely true in the real world? Please use a specific example to explain why PPP does not hold true even for a fairly standard product like a Big Mac.

Answer 1

Let us answer the question as below in a general perspective to arrive at answers of the specific questions.

Let us first understand the basic of various aspects involved in foreign exchange rate in a simple manner.
Foreign exchange rate is the rate at which currency of one country can be exchanged for currency of another country.
Exchange rate is determined in the foreign exchange market. The dealers of the foreign exchange market are central bank of the country, commercial banks, foreign exchange brokers, importers, exporters, investors, international tourists and immigrants of the respective country.

There are two theories of foreign exchange rate determination. Those are, free market theory and purchasing power parity theory. Under free market theory, exchange rate is determined by the market forces, i.e. the demand for and supply of foreign exchange. Under purchasing power parity theory (PPP), exchange rate between any two currencies is determined on the basis of their comparable purchasing power in terms of the same basket of products. It asserts that the relative value of different currencies correspond to the relation between the real purchasing power of each currency in its own country or we can say under inconvertible paper currency system , the rate of exchange between any two currencies is determined on the basis of their purchasing power in their respective countries.

There is criticism of purchasing power parity theory (PPP) of exchange rate. Those are PPP helps only in determining the change in exchange rate, not the absolute exchange rate; the wholesale price index number on which PPP is based does not give an accurate measure of change in purchasing power; based internationally traded goods and services, but the whole sale price index number includes prices of all the commodities; imposition of embargo and tariffs and provision of export subsidy often cause deviations in the purchasing power which are not accounted for by the PPP theory; change in exchange rate depends mainly on the elasticity of reciprocal demand whereas PPP recognizes the changes in the exchange rate due to changes only in the relative prices; PPP theory assumes that the relative commodity prices are the sole determinants of international transactions and change in the relative prices is the sole determinant of exchange rate, but changes in exchange rate also take place due to disequilibrium caused by capital transfers, service payments and change in real income.

However this theory (PPP) can be used as the first approximation to an equilibrium rate of exchange during the periods of high and frequent price changes.

Big Mac index is a guide simply which pits value of currencies around the world against one another by comparing the local price of an Mcdonald's Big Mac burger .This index uses the idea that the excange rate should be a relection of what people are paying in one country compared to purchasing power parity theory (PPP) as stated above.

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