Exchange Rates

            Every country has a different form of currency around the world. So, an amount of one countries currency will not equal the others. This is why we have exchange rates. Exchange rates show the price of one currency in terms of another currency. The purchasing power parity is a theory that says that a product in one country will sell for the same price in another country when they are expressed in the same currency. Purchasing power parity states that the exchange rates will adjust so that one unit of currency will buy the same about of goods and services all over the world.

            To test this theory, we will look at the price of the Macdonald’s Big Mac sandwich in selected countries that we would expect to see with purchasing power parity and the actual prices in those countries. To find the expected prices based on purchasing power parity we will find the exchange rate of the selected countries compared to one U.S. dollar and multiply it by the price of the actual price of a Big Mac in the U.S.; which is $3.06. The results are shown in the table below.

            Looking at the table, we can see if the purchasing power parity theory is true. Some of the actual prices come close to the expected prices, but the majority of the actual prices are either much higher or much lower than the expected prices using purchasing power parity. For instance in Iceland, the expected price compared to the price of $3.06 in U.S. dollars is 186.26 Icelandic krona, but the actual price is 410 Icelandic krona. This means that the same $3.06 used to buy a Big Mac in the U.S. could not buy a Big Mac in Iceland; it would cost you a lot more. On the other hand in Japan the actual price is 260 Japanese yen and the expected price is 349.05 Japanese yen. This means that the same $3.06 in the U.S. would buy you more than one Big Mac in Japan. Looking at the evidence, the purchasing power parity appears to be incorrect. Some of the factors that can affect the purchasing power parity are barriers to trade and transportation costs. For example, if a country has to import the beef to make the Big Mac and the beef has a tariff on it, then the price of the Big Mac will be higher in that country than a country that can produce its own beef. Or, if the country has to import the beef from far away, then the cost of transportation will be high. Furthermore, the cost of transportation has to be compensated by higher prices for the Big Mac. The evidence from the table above do not support the purchasing power parity theory, but there could be factors that affect the prices and make the purchasing power parity incorrect in this situation.

Calculations finding expected prices

Exchange rate (as of 8:00 PM, 10-16-05) * the price of a Big Mac in U.S dollars (3.06)