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Identifying the Purchasing Power Parity of Indonesia Rupiah (Idr) Based on Big Mac Index

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Identifying the Purchasing Power Parity of Indonesia Rupiah (Idr) Based on Big Mac Index Avalaible online at http://journals.ums.ac.id Jurnal Ekonomi Pembangunan, 17 (2), December 2016, 210-231 IDENTIFYING THE PURCHASING POWER PARITY OF INDONESIA RUPIAH (IDR) BASED ON BIG MAC INDEX Tongam Sihol Nababan Faculty of Economics, University of HKBP Nommensen, Jln. Sutomo No. 4A Medan, Indonesia, Phone : 061-4522922. Corresponding E-mail : [email protected] Recieved: November 2016; Accepted: December 2016 Abstract The aim of this study is to identify : (1) profile of exchange rate and purchasing power parity of IDR against US $ based on Big Mac Index compared to the exchange rate of other countries, and (2) the position of the Big Mac Affordability of Indonesia compared to other ASEAN countries. The results showed that based on Big Mac index during the period April 1998 up to January 2015, IDR exchange rate tends to be undervalued against the USA dollar. The cause of the currency tends to be in a position of undervalued due to the components of nontradables have not been included in Big Mac index. The index of Big Mac Affordability indicates that there is a great disparity of income between Singapore and five other ASEAN countries. The purchasing power of the real income of the people in Singapore is nearly five times the real income of the people in Indonesia. Keywords: Big Mac Index, Affordability, exchange rate, purchasing power parity, undervalued and overvalued, tradables and nontradables. JEL Classification: E43 F41 G15 1. Introduction A theory used to explain the behavior of As a country with an open theeconomy, currency exchange rate is the theory of Indonesia has done a lot of economic cooperation Purchasing Power Parity (PPP). Kuncoro (2015) with other countries, especially in the field of argues that comparisons between countries based international trade. To get the optimum benefit on the Gross National Income (GNI) per capita from economic transactions, the role of the is often misleading. This happens due to the exchange rate system with foreign exchangeconversion is of the income of a country into the very important. According to Kuncoro (2015) the same currency at the official rate (for example : importance of foreign exchange rates, due to it the US dollar). The nominal exchange rate does deals directly with the sectors of international not reflect the relative ability of the purchasing trade, investment, and even directly related power of different currencies, so the errors can to the foreign debt as a source of development arise when comparing the performance of some funding. Determining foreign exchange rates countries. Therefore, PPP is recommended as have a great influence on the costs and benefitstoa more appropriate means of the converter in be obtained in international trade. There are converting GNI in local currency to the dollar. many things that can affect changes in exchangeOne method that can measure the concept of PPP rates, such as inflation, interest rates, nationalis the Big Mac index, also known as Big Mac PPP income, government restrictions, and predictions or Burgernomics. Big Mac index is published by of market exchange rate in the future (Madura, The Economist magazine (from 1986) as a way of 2006). measuring the purchasing power parity between 210 Jurnal Ekonomi Pembangunan, ISSN 1411-6081 Avalaible online at http://journals.ums.ac.id Jurnal Ekonomi Pembangunan, 17 (2), December 2016, 210-231 two currencies, and give a test of the extent to Until now, Indonesia still applies the system which market exchange rate result in goods with of free floating exchange rate. The implementation the same cost in different countries. This index is of this exchange rate has caused the IDR to be trying to make exchange rate theory a bit easier weak and has slowed the economic growth. to digest (Wikipedia, 2016). Simorangkir and Suseno (2004) said that the fall In this context, the term of “goods” is defined of IDR was mainly due to higher capital outflows simply as a kind of the hamburger type, named and increase of speculative activities against Big Mac, produced by McDonald franchise the IDR, and also the condition of social and company. According to Ong (2003) the Big Mac political stability. The strong influence of social Index is a more palatable solution to the index-and political instability on the development of number problem, given that this hamburger the exchange rate is reflected in the movement of is produced locally in more than 100 countries the exchange rate in line with the development of around the world, with only minor changes ineconomic, social, and political in the country. The recipe, and thus has the flavour of ‘the perfectIDR exchange rate still continues to depreciate universal commodity’. Up to now, a type of Bigagainst the US dollar as the benchmark currency Mac is believed to be a universal perfect product in the world. Therefore, to observe movements or because it has been produced locally in more than fluctuations of the IDR, the PPP model with the 120 countries, including Indonesia. It means, Big Mac index is more relevant when applied. To that Big Mac PPP is the exchange rate showingfind out if the exchange rate trading at the right that Big Mac hamburger have the same price in level, then simply index Big Mac can be used to all countries. The main objective to compare a determine whether a currency is in line with the country’s currency with the Big Mac PPP is totrue value or overvalued (higher than the actual determine whether the currency is considered value) or even undervalued (lower than the actual undervalued or overvalued against the other value) currency, such as US dollar (Olivon, 2013). Therefore, this study analyzed how the Indeed, the Big Mac index is not a perfect position of the Indonesia Rupiah (IDR) exchange measure of PPP. Price differences may be rate compared with other countries based on the distorted by trade barriers on beef, sales indextaxes, Big Mac. This study also analyzed how the local competition and changes in the cost of non- development of IDR based on the Big Mac index traded inputs such as rents. But despite its flaws, from 1998 to 2015 according to the availability the Big Mac index produces PPP estimates close of data from The Economist. Atal (2014) states to those derived by more sophisticated methods. A that Big Mac index model (Burgernomics) have currency can deviate from PPP for long periods, but been widely used to measure other indicators several studies accomplished by Alfheim (2015), as was done by Hoefert and Hofer (2006). They Portes and Atal (2014), Chen et al (2007) have discovered how many hours the average that found that the Big Mac PPP is a useful predictor worker had to work to get enough money to buy of future movements. So, the significance of this a Big Mac burger in a country. It provides an study lies on the widespread use of the index and information about the differences of wage level in thus perpetuation of perceptions on the relative some countries. value of currencies in the areas of corporate Besides, it is necesssay to know the Big Mac finance, international trade and finance, dailyand affordability for countries to measure the international business. It should appeal not only inequality of real income per capita. This analysis to economic researchers and policy-makers but can tell us that the cheap price of a burger not also to those who must deal with exchange ratenecessarily affordable when the factor of income issues in day-to-day business decisions. per capita taken into account (Caetano, et al, Jurnal Ekonomi Pembangunan, ISSN 1411-6081 211 Avalaible online at http://journals.ums.ac.id Jurnal Ekonomi Pembangunan, 17 (2), December 2016, 210-231 2004). In this study, Big Mac daily affordability that the main difficulties associated with the is analyzed in some ASEAN countries, such implementation of the PPP theory are : (1) the as Indonesia, Malaysia, Singapore, Thailand, problem of identifying the items which should be Philippine, and Vietnam. Therefore, the purpose subject to the law of one price, (2) how to weight of the study is also to analyze the profile of the relevance of the items in each market, and purchasing power parity of IDR compared with (3) how the relative weights of these goods in the other countries based on Big Mac index, as well as market. Complicating this issue indicates that the to determine the position of Big Mac Affordability goods being compared will continue to change. For of Indonesia compared to other ASEAN countries. example, such as computers and other electronic gadgets. 2. Literature Review PPP theory is divided into two versions : 2.1. Theory of Purchasing Power Parity absolute version and relative version. Absolute (PPP) version of PPP theory is often associated with the A Swedish economist, Gustav Cassel, in theory of the Law of One Price despite the fact the early of 20th century has popularized the that there is a difference between the two. The purchasing power parity (PPP) as the essencetheory of the Law of One Price is applied only to of exchange rate theory. Theory of PPP assumesone type of goods while the PPP theory is applied that in some circumstances (for example, as toa the overall price level by using a basket of goods long-run tendency) it would cost exactly the sameand services. number of, for example, US dollars to buy euros According to Alfheim (2015) the historical and then to use the proceeds to buy a market PPP hypothesis is based on the well known law basket of goods as it would cost to use those dollarsof one price concept. Simplistically speaking directly in purchasing the market basket of goods.
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