The Economist releases its annual Big Mac Index. Often they use the Big Mac purchasing power parity index to determine the likely trajectories of currencies by seeing which ones are over or undervalued. They do, however, concede a couple of exceptions. First,
there are some persistent deviations from PPP. In particular, emerging-market currencies are consistently undervalued. Differences in productivity are one explanation of this. Rich countries have higher productivity than poor countries, but their advantage tends to be smaller in non-tradable goods and services than in tradables. Because wages are the same in both sectors, non-tradables are cheaper in poorer countries. Therefore, if currencies are determined by the relative prices of tradables, but PPP is calculated from a basket that includes non-tradables, such as the Big Mac, the currencies of poor countries will always look undervalued.
The news media would be wise to keep that logic in mind when citing that a given third world resident lives on $30 a year, say. Such claims are true if you look at exchange rates based on traded goods, but not at prices that third world inhabitants face. Not to minimize the serious extent of poverty, but we shouldn’t be taken in by illusions of the exchange rate.
Second, in addition to the prices of goods, the demand for financial assets also determines currency exchange rates - for this reason the Economist suggests that the US’s current account deficit will likely push the dollar down below purchasing power parity. Which means we’ll possibly be paying a lot more for Big Macs and consumer items in general in the not distant future.
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