2 management - School of International Business and ...

165 The Puzzle of Globalization
As the assumptions to achieve this equilibrium are extremely restrictive (e.g. fully integrated goods
markets, no trade barriers, no transactions costs), empirical tests show mixed results [Wang, 2009,
pp 42-47]. In general, studies that use very long sample periods achieve better results regarding
the validity of the PPP than tests based on shorter periods of time. More than ten years ago THE
ECONOMIST introduced the Big Mac Index for estimating the PPP. The advantages of the index
are the simple data collection (exchange rate and Big Mac prices in two countries) and the relative
high homogeneity of this product, its all day consumption character (representing a basket of dif-
ferent goods) and its nearly global availability. The most important disadvantage is the fact that the
Big Mac is a non-traded good. The calculation (Table 2) starts with the Big Mac price in the U.S.A.,
then searching for the price in local currency, e.g. for the Euro. The expected PPP is 1.21 ($ 4.33
divided by Euro 3.58). The US Dollar price of the Euro Zone Big Mac results from multiplying the
price in Euro by the current exchange rate (Euro 3.58 x 1.21 = $ 4.34). By comparing the actual
exchange rate with the Big Mac PPP, the outcome indicates whether a currency is over- or under-
valued (Figure 14).
Country BM price in
local currency
BM price in USD Implied
purchasing
power
U.S.A. 4.33 4.33
Actual USD
exchange rate
Under (-)/
Over
(+) Valuation
China 15.65 2.45 3.62 6.39 - 43
Euro Area 3.58 4,34 1.21 1.21 0
Japan 320 4.09 73.95 78.22 - 5
Norway 43 7.06 9.94 6.09 + 63
Russia 75 2.29 17.33 32.77 - 47
Table 2 | Calculation of the Big Mac Index, Selected Countries, July 2012
Source: http://bigmacindex.org
Both the short-term fluctuations of exchange rates and their long-term deviations from the PPP
are putting pressure on national and international policy makers to stabilize currency markets.
The Bretton Woods conference in 1944 ended up with the agreement of 44 countries to introduce
a fixed exchange rate system with the US Dollar as the key currency and the obligation of the
Federal Reserve Bank of New York (FED, central bank of the U.S.A.) to change Dollar reserves
against gold a the fixed rate of one ounce gold equals US Dollar 35. Since the collapse of the
Bretton Woods system of fixed exchange rates at the beginning 1970s, the diversity of exchange
rate systems increased drastically (Figure 15).