This paper will introduce the concept of Purchasing power parity, and specifically how the Big Mac has been used to apply this concept. It will critically assess whether the Big Mac is a worthy instrument for measuring PPP, the critical issues when measuring PPP, and a possible alternative that might provide a suitable substitute, should the Economist decide to use other products to replace their “Big Mac Index”.
Purchasing Power Parity
Purchasing Power Parity (PPP) is a theory, which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. Therefore when a country's domestic price level is increasing, that is a country experiences inflation, if PPP holds then it follows that country's exchange rate must depreciate in order to return to equilibrium.
The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalise the price of an identical good in two countries when the prices are expressed in the same currency. Otherwise there is an arbitrage opportunity (arbitrage being defined as “the simultaneous purchase and sale of substantially identical assets in order to profit from a price difference between the two assets” Wall Street Words: An Essential A to Z Guide for Today's Investor by David L. Scott, © 1997, 1998 by Houghton Mifflin Company).
If arbitrage is carried out at a large scale, the consumers buying foreign goods will bid up the value of the foreign currency, thus making those goods more costly to them. This process continue ...