International Finance Case Study 201: The Big

Case Studiesinternational Financecase Study 201 The Big

The provided case study discusses the Big Mac Index, a light-hearted economic measure used by The Economist magazine to assess whether currencies are overvalued or undervalued relative to the U.S. dollar. The index compares the price of a Big Mac across various countries, converting local prices into U.S. dollars based on prevailing exchange rates. The core premise of the index is to test the Purchasing Power Parity (PPP) theory, which suggests that, in the long run, exchange rates should adjust to equalize the price of a basket of identical goods across countries. The index reveals that, due to various factors such as transportation costs, taxes, wages, and tariffs, actual prices deviate significantly from what PPP would predict. Consequently, the findings from the Big Mac Index often contradict the straightforward expectations of the PPP theory.

Critically analyzing why the Big Mac Index may not be a valid test of the PPP theory involves understanding its limitations. First, the index uses a non-traded good—the Big Mac—which is subject to numerous local factors that do not primarily relate to exchange rate movements. For example, differences in wages, rent, and local taxes substantially influence the price of a Big Mac in different countries. Wages, in particular, serve as a significant determinant; in the United States, the average wage for a McDonald's worker is significantly higher than in countries like China or India. These labor cost disparities cause differences in Big Mac prices that are unrelated to currency valuation. Therefore, the index oversimplifies currency valuation by assuming a homogenous basket of goods that are not internationally traded and do not reflect market prices for tradable goods.

Secondly, trade barriers such as tariffs and quotas distort the prices of commodities and inputs used in the production of Big Macs. For instance, a country with high import tariffs on beef or imported packaging will have higher costs for producing a Big Mac than what exchange rates alone would predict. Similarly, local regulation, supply chain differences, and cultural preferences influence the ultimate price. For example, in countries with strict health regulations, costs may be higher, inflating the local Big Mac price independently of the currency's real value. This makes the index less precise in assessing currency valuation as it captures local economic factors rather than the real purchasing power of the currency.

Another aspect to consider is that the PPP theory specifically pertains to traded goods—those that can be exchanged internationally. Since the Big Mac is largely a domestically consumed good, its price deviations do not necessarily reflect exchange rate misalignments but rather local economic and structural factors. As a result, the observed overvaluation or undervaluation indicated by the index may be attributed more to local cost structures than to the actual currency's value relative to its purchasing power.

Furthermore, differences in currency overvaluation or undervaluation, as identified by the index, often do not account for financial market interventions or speculative activities that influence currency values independently of domestic price levels. Many countries, including China and Japan, actively intervene in foreign exchange markets to influence their currencies for trade advantages, leading to discrepancies between the index's indication and the actual currency valuation.

References

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