Purchasing Power Parity (PPP) is a concept in economics that states that exchange rates between two countries should be a point where the price of a basket of goods, once adjusted for the exchange rate, is identical between the two countries.
The Purchasing Power Parity exchange rate is the exchange rate that makes a basket of goods the same price between two countries. In this exercise we will investigate whether this is the case, or whether countries have currencies which are overvalued or undervalued against each other.
To illustrate this concept we will use the Big Mac Index from The Economist. This index was set up as a bit of a joke, but it has since become a bit serious. The Economist tracks the price of Big Macs (a good sold around the world) along with the exchange rate for different currencies. You can find an explanation (and the data) here: https://www.economist.com/big-mac-index.
Task: Select some countries that you think would be interesting. Look at the figures. See if you can work out whether the country’s currency is overvalued or undervalued against the pound.
Country:
Name of Country:
Price of Big Mac in UK: GBP
Price of Big Mac in :
Nominal Exchange Rate: per GBP
Source: Big Mac Index,
What is the price of Big Macs in in pounds?
How many big macs could I buy in if I got off the plane with the money I would expect to pay for a big mac in the UK?
What should the Purchasing Power Parity exchange rate be for this country?
How does this PPP exchange rate compare to the actual (nominal) exchange rate?
Is this currency overvalued or undervalued? Extension: what percentage of the exchange rate is the PPP over-valued or under-valued by?