Question

8. Purchasing-power parity

Using data from The Economist's Big Mac Index for 2016, the following table shows the local currency price of a Big Mac in several countries as well as the actual exchange rate between each country and the United States. At the time of the data collection, a Big Mac would have cost you $4.93 in the United States and GBP 2.89 in the United Kingdom. The actual exchange rate between the British pound and the U.S. dollar was $1.63 per pound. The dollar price of a Big Mac purchased in the United Kingdom was, therefore, computed as follows:

Dollar price of a Big Mac in the United KingdomDollar price of a Big Mac in the United Kingdom	=  =	GBP 2.89×$1.63GBP 1.00GBP 2.89×$1.63GBP 1.00
	=  =	$4.71$4.71

For the price you paid for a Big Mac in the United States, you could have purchased a Big Mac in the United Kingdom and had some change left over for fries!

Complete the final column of the table by computing the dollar price of a Big Mac for the countries where this amount is not given.

Note: Round your answers to the nearest cent.

	Big Mac Index: January 2016
	Local Price	Actual Exchange Rate	Dollar Price
	(Foreign currency)	(Dollars per unit of foreign currency)	(Dollars)
The Eurozone	3.72	1.10
Norway	46.80	0.12
United Kingdom	2.89	1.63	4.71
Poland	9.60	0.36	3.46
China	17.60	0.16	2.82

Source: “Currency Comparison, To Go,” The Economist, last modified January 7, 2016, accessed July 8, 2016, http://www.economist.com/blogs/graphicdetail/2016/01/daily-chart-7.

Purchasing-power parity (PPP) theory states that exchange rates would need to equalize the prices of goods in any two countries. For the dollar price of a Big Mac to be the same in both countries, a U.S. citizen would need to be able to convert $4.93 into exactly GBP 2.89. To find the exchange rate at which hamburger purchasing power is the same in both countries, divide the price in the United States by the price in the United Kingdom:

PPP Exchange Rate (U.S. Dollars per British pound)PPP Exchange Rate (U.S. Dollars per British pound)	=  =	$4.93GBP 2.89$4.93GBP 2.89
	=  =	$1.71 per pound$1.71 per pound

The exchange rate that would have equalized the dollar price of a Big Mac in the United States and the Eurozone (that is, the PPP exchange rate for Big Macs) is . This change would mean that the euro had against the dollar.

If Big Macs were a durable good that could be costlessly transported between countries, which of the following would present an arbitrage opportunity? Check all that apply.

Exporting Big Macs from Poland to China

Exporting Big Macs from Norway to China

Exporting Big Macs from the Eurozone to the United States

Answer 1

The first task in answering this question is filling the table to find the Dollar price given the local price and the Exchange rate. You can find this by multiplying The local price and the exchange rate in USD. For the Eurozone, the dollar price is 3.72 * 1.1 = 4.092 and round this to the nearest cent a 4.10. For Norway, the dollar price is 46.8 * 0.12 = 5.616 and rounding this off, you get 5.62.

The second concept here is the Purchasing Power Parity. For a good to be priced the same in 2 countries, what would be the exchange rate? This is what we find here. We are finding the exchange rate where the hamburger purchasing power is equated across 2 countries. The first question here is the exchange rate that would have equated the purchasing power in US and the Eurozone. Find this by dividing the the price in US by the price in Eurozone. It is 4.93/3.72 = 1.3252 This is PPP Exchange rate. The second question is what this means for Euro against USD. To answer, compare PPP exchange rate with actual exchange rate. Actual rate is 1.1 PPP rate is 1.3252. This means Euro has appreciated against USD in real terms of output.

The third party of the question is about the arbitrage opportunity. Now if we costlessly export from Poland to China, we have to have a common scale. In poland it costs 3.46 whereas it costs 2.82 in China in terms of USD, Hence there is no profit in exporting to china. Similary it costs 5.616 USD in Norway and it is not profitable to export to China where it costs 2.82. The third choice of exporting from Eurozone to US is correct. It costs 4.092 dollars in Eurozone but 4.93 in US. An exporter can buy at 4.092 in Eurozone and sell for 4.93 in US and make profits due to this arbitrage opportunity. Hence this is the correct answer.