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(Big Mac) Exchange Rate Theory

(Big Mac) Exchange Rate Theory. Roberto Chang Econ 336 February 2014. The Law of One Price. In Economics , we often postulate the Law of One Price: the same good should sell at the same price in different locations .

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(Big Mac) Exchange Rate Theory

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  1. (Big Mac) Exchange RateTheory Roberto Chang Econ 336 February2014

  2. TheLaw of One Price • In Economics, weoftenpostulatetheLaw of One Price: thesamegoodshouldsell at thesameprice in differentlocations. • Why? Ifnot, therecould be arbitrage: youcouldmake a profitbybuyingthegoodwhereitischeaper and sellingitwhereitis more expensive.

  3. Limitstothe “Law” • Obviously, transportationcostsmaymatter. • Buttheymaynot be so importantfor “big” items (i.e. cars) • Youmightalsofindthatpeoplecannoteasilyarbitrageduetoe.g. legal issues

  4. Nevertheless… • Sometimes (often) economistsbelievethattheLaw of One Price mustholdat least in thelongrun, providedonecorrectsfortransportationcosts.

  5. TheLaw of One Price in an International Context • OnemayalsobelievethattheLaw of One Price shouldholdacrosscountries as well. • Now: goods are priced in differentcurrencies • So: one can postulatethatexchangerates in thelongrunadjust so thattheLaw of One Price holds  Thiswill lead to a theory of exchangerates in thelongrun

  6. The Big Mac Theory • A Big Mac is a standard, homogenous, product • So itshouldsellforthesamepriceeverywhere in thelongrun • So, in a longrunequilibrium, theexchangerateshouldequalizeprices of Big Macs in differentcountries.

  7. Current Big Mac Prices • Price of a Big Mac in the US: $ 4.20 • In Brazil: 13.66 BRL • Let x = theexchangerate ($ per BRL) thatmakesthetwopricesequal. Then $ 4.20 = x times 13.66 BRL i.e. x = 4.20/13.66 = 0.307$/ BRL

  8. IstheBRLOvervalued? • So, according to the Big Mac Theory, the “equilibrium” Dollar/BRL exchangerateshould be 0.307 • Today: marketexchangeratewas0.416dollar per BRL • So, according to this, theBRLisabout35 percentovervaluedrelative to thedollar!

  9. Big Mac Index, June 2009 (fromTheEconomist)

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