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The Big Mac Index This page intentionally left blank The Big Mac Index Applications of Purchasing Power Parity Li Lian Ong © Li Lian Ong 2003 Foreword © Bill Shields 2003 Softcover reprint of the hardcover 1st edition 2003 978-1-4039-0310-5 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1T 4LP. Any person who does any unauthorized act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted her right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. First published 2003 by PALGRAVE MACMILLAN Houndmills, Basingstoke, Hampshire RG21 6XS and 175 Fifth Avenue, New York, N.Y. 10010 Companies and representatives throughout the world PALGRAVE MACMILLAN is the global academic imprint of the Palgrave Macmillan division of St. Martin’s Press, LLC and of Palgrave Macmillan Ltd. Macmillan® is a registered trademark in the United States, United Kingdom and other countries. Palgrave is a registered trademark in the European Union and other countries. ISBN 978-1-349-50855-6 ISBN 978-0-230-51241-2 (eBook) DOI 10.1057/9780230512412 This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. A catalogue record for this book is available from the British Library. Library of Congress Cataloging-in-Publication Data Ong, Li Lian. The Big Mac index : applications of purchasing power parity / Li Lian Ong. p. cm. Includes bibliographical references and index. 1. Purchasing power parity. 2. Foreign exchange rates. I. Title. HG3821 .525 2002 332.4Ј1–dc21 2002033302 10 9 8 7 6 5 4 3 2 1 12 11 10 09 08 07 06 05 04 03 For Mum and Dad This page intentionally left blank Contents List of Tables ix List of Figures x Foreword by Bill Shields xi Preface xiii Acknowledgements xv Notes on the Contributors xvi 1 Purchasing Power Parity: A Survey of the Issues 1 Introduction 1 Absolute and relative parities 2 The index-number problem 4 Determining the equilibrium exchange rate 9 The productivity bias hypothesis 12 Further qualifications to PPP 17 Summary 23 2 The Growing Evidence on Purchasing Power Parity 29 Co-authored with Yihui Lan Introduction 30 The ‘trends’ in PPP research 31 Empirical evidence in the 1990s 34 The Economist’s Big Mac Index 41 Summary 43 3 The Economics of the Big Mac Standard 51 Introduction 52 The data 53 The valuation of currencies 55 Geographic effects 61 Further tests of Big Mac PPP 65 Relative parity 68 Possible causes of deviations from parity 69 vii viii Contents Is the Big Mac all tradeable? 71 Improving the Big Mac Index: the No-Frills Index 76 Conclusion 77 Appendices 78 4 ‘Burgernomics’ and the ASEAN Currency Crisis 88 Introduction 88 Currencies in crisis 90 5 Big Macs and Wages To Go, Please: Comparing the Purchasing Power of Earnings Around the World 92 Introduction 93 On paycheques and purchasing power 95 Who gets what where? 98 Further extensions: accommodation and transportation 100 Conclusion 105 6 Professors and Hamburgers: An International Comparison of Real Academic Salaries 109 Co-authored with Jason D. Mitchell Introduction 110 Comparisons of purchasing power 113 Quality of life 117 Conclusion 118 Index 123 List of Tables 2.1 Summary of PPP research in the 1990s 36 2.2 Big Mac Index search results 43 3.1 Domestic currency valuation relative to the US dollar, 1986–94 56 3.2 Tests of domestic currency valuation relative to the US dollar, 1986–94 averages 59 3.3 Tests of world currency valuations relative to the US dollar: annual cross-country averages, 1986–94 61 3.4 Tests of domestic currency valuation relative to the US dollar by region, 1986–94 averages 63 3.5 Regression results: exchange rates and prices, 1986–94 66 3.6 Regression results: currency valuation and GDP— cross-country/time-series, 1986–94 75 A3.1 Actual exchange rates, the Big Mac Index and the No-Frills Index 80 5.1 Real wage differentials relative to the US, 1988–94 averages 97 5.2 Regression results: relative real net wages, market status and geographic location, 1988–94 99 5.3 Real cost of living differentials relative to the US, 1988–94 averages 101 5.4 Real net wages after taxes, accommodation and transportation costs, 1988–94 averages 103 6.1 Academic salaries: country averages, 1997 112 6.2 The Big Mac Index, 1997 113 6.3 Real academic salaries: country averages, 1997 115 6.4 Index of gross and net salaries: country averages, 1988–94 117 6.5 ‘Places to live’ rankings 118 ix List of Figures 2.1 The growth of economic research 31 2.2 Estimates of PPP half-lives 33 3.1 The hamburger standard 54 3.2 Valuation of currencies, 1986–94 averages 58 3.3 Valuation of currencies: annual cross-country averages, 1986–94 60 3.4 Valuation of currencies: regional groups, 1986–94 averages 62 3.5 Exchange rates and prices: country averages, 1986–94 68 3.6 Exchange rate movements: cross-country/ time-series, 1986–94 70 4.1 Valuation of currencies based on the ‘old’ and ‘new’ US Big Mac prices 89 5.1 Relative real net wages and real GDP per capita, 1988–94 98 5.2 Relative real wages by region: 1988–94 averages 100 x Foreword In this book Li Lian Ong draws on her earlier doctoral research and more recent experience working in international financial markets to review and enhance the use of purchasing power parity (PPP), or relative prices, in the analysis of exchange rates. PPP has a long history in academic and applied research. Despite obvious difficulties in utilizing it to forecast exchange rates in the very short term, reflecting the presence of a number of other influ- ences including the increased role and volatility of market expecta- tions, in particular concerning relative asset prices and changes in the stance of monetary policy, PPP continues to be used in economic analysis such as in the estimation of relative standards of living between countries. For her analysis Li Lian adopts the popular Big Mac (hamburger) index, which was pioneered and is regularly updated by The Economist magazine, to outline a novel and potentially useful enhancement to PPP for use in understanding the likely trends in exchange rates. The first two chapters of the book provide a comprehensive review of both the theory and past empirical research into PPP, and discuss the problems associated with estimating PPP exchange rates due to well-known complications associated with the measurement of rele- vant price series, market imperfections and structural change. The application of PPP to the determination of equilibrium exchange rates is also discussed, including the important question of the direc- tion of causality between relative prices and exchange rates. However, Li Lian’s main focus is on the importance of productivity bias – or the differences across countries in rates of growth in pro- ductivity between the traded and non-traded sectors – when using PPP to estimate equilibrium exchange rates. Her analysis in Chapter 3 first shows that the Big Mac index has been a generally reliable guide to the year-on-year trends in exchange rates, and even more so over the longer term. Nevertheless, several persistent discrepancies are identified, which she estimates are most importantly related to productivity differentials between countries. Li Lian adjusts for this bias by excluding the costs of those inputs xi xii Foreword that are not traded (basically services), which she estimates account on average for 93 per cent of the price of the hamburgers. Li Lian shows that this adjustment, and her resulting No-Frills Index, consid- erably enhances the tracking of exchange rates over the long term. While the use of hamburger prices to test the applicability of PPP to exchange rates may be challenged in terms of some of the mea- surement and conceptual issues reviewed in earlier chapters, this approach rather effectively combines a well-established and popular measure of the over- and undervaluation of currencies with differ- ences in productivity growth, which has been a significant issue in recent economic debate about relative growth rates and standards of living. As such, it should appeal not only to economic researchers and policy-makers but also to those who must deal with exchange rate issues in day-to-day business decisions. The final three chapters of Li Lian’s book provide examples of how this approach can be used. Chapter 4 provides a brief assessment of the 1997 ASEAN currency crisis – extending Li Lian’s analysis to include other countries affected by that and similar currency crises, for exam- ple Korea and Brazil, would broaden its appeal to policy-makers. Two more business-oriented applications are discussed in Chapters 5 and 6, and may have more immediate appeal to potential users. In particular, the suggested application of this approach to the estima- tion of real costs of living and relocation expenses is relevant to the globalized nature of many business operations, and the inevitable consequences for costs as a consequence of increased staff mobility. Li Lian’s book makes a very useful addition to the literature on pur- chasing power parity by providing an enhanced approach for those who continue to apply PPP to the analysis of exchange rates, both what determines them and their consequences for economic policy and business decisions.