The theory of Purchasing Price Parity is hard to digest because of the fact that is so abstract and it does not apply non-tradable goods. PPP is a theory that states all goods will cost the same across borders, because if one country charges more then consumers will change their spending patterns. There are a number of assumptions perfect information, immediate capital flows, etc. The theory does have relevancy in the currency market, because it can help traders distinguish over valued currencies. The Big Mac index developed by the Economist magazine is a great way to explain the theory. Essentially the Economist traveled the world and found out the price of a Big Mac in every country and expressed the price in dollars. The current price of a Big Mac in America is $3.57 where as the Euro Area has a price of $5.34. This gives the impression that the Euro is overvalued by 33 percent. Norway has the bargain price of $7.88 for a Big Mac which is expected because Norway suffers form the Dutch disease because oil has risen so fast.
On the other hand China, Malaysia, and Hong Kong all have Big Macs for fewer than two dollars. Leading to the conclusion that the Yuan needs to appreciate 110 percent until equilibrium is reached. The data confirms suspicion that Asian currencies are undervalued in order to promote their export sectors. They do this by buying large reserves of U.S. Treasuries to increase the value of the dollar. The Big Mac is a global commodity consumed world wide with the same ratio of pickles, onions, and ketchup which makes it a great example for PPP. I would not base trades on Big Mac prices but it does confirm suspicions as to whether certain currencies are undervalued or not. Thus the Big Mac index of 2008 concludes that the Euro Area is over valued and the Asian currencies are undervalued
On the other hand China, Malaysia, and Hong Kong all have Big Macs for fewer than two dollars. Leading to the conclusion that the Yuan needs to appreciate 110 percent until equilibrium is reached. The data confirms suspicion that Asian currencies are undervalued in order to promote their export sectors. They do this by buying large reserves of U.S. Treasuries to increase the value of the dollar. The Big Mac is a global commodity consumed world wide with the same ratio of pickles, onions, and ketchup which makes it a great example for PPP. I would not base trades on Big Mac prices but it does confirm suspicions as to whether certain currencies are undervalued or not. Thus the Big Mac index of 2008 concludes that the Euro Area is over valued and the Asian currencies are undervalued
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