Global Financing and Exchange Rate Mechanisms

Posted: October 17th, 2013

Global Financing and Exchange Rate Mechanisms

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Global Financing and Exchange Rate Mechanisms

The Economist publishes the Big Mac Index in an informal method of valuing the purchasing power parity of two different currencies. Additionally, the Big Mac Index gives a provision test for the extent at which the exchange rates in the market lead to the same cost of goods in different countries. It looks to make the concept behind the exchange rate theory more understandable.

Overview

Pam Woodall through the Economist introduced the Big Mac Index on September 1986 in a semi-illustration, and its publication has been done annually since its inception. The index also led to the development of the phrase “burgernomics.” Research by the UBS Wealth management endeavored to expand the Big Mac Index aspect to include the minimum working time required by an average worker from a given country for his or her earnings to purchase sufficiently the Big Mac (Clements and Seah, 2012). The Big Mac index based on working time seemingly gives a realistic view of an average workers purchasing power since it takes into consideration more influencing factors including local wages.

One method suggested for predicting the rate of exchange movements involves naturally adjusting the rate between the two currencies so that sample goods and services should exhibit the same purchase cost in both currencies (purchasing power parity). For the Big Mac Index, sample goods and services represent one Big Mac burger as retailed by McDonald’s restaurant chains (Clements and Seah, 2012). In this case, the Big Mac choice was due to its availability to common specification in numerous nations similar to the theoretical franchisees of McDonald’s fast food chain restaurants that have significant negotiating responsibility on input prices. These reasons ultimately enable the Big Mac Index making a comparison of currencies from many countries.

The Big Mac purchasing power parity rate of exchange between two given countries is attained by dividing the Big Mac price (currency) in one country by the Big Mac price (currency) of another country. The attained value is from this point compared with the rate of exchange. If the resultant value is lower, then the PPP theory requires the first currency be undervalued compared with the second. Conversely, if the value is higher, then theory demands an over-valuation of the first currency.

Variants

In certain publications, the economist provides variants regarding the Big Mac index theme. For instance, January 2004 oversaw the Big Mac Tall Latte index replaced by the Starbucks cup of coffee. In 2007, the subsidiary of an Australian bank and common securities allied the aspect relating to the Big Mac index in developing an “iPod index”. The theory of the bank maintained that since the manufacturing of the iPod occurs from a single place, then the iPod value should be consistent worldwide (Clements and Seah, 2012). However, this theory warrants criticism for its ignorance on shipping costs. Realistically, the variation of these costs depends the distance of the product’s delivery from its place of manufacture, in this case, China.

Limitations

While economists vastly regard the Big Max index as an efficient tool for measuring real-world purchasing power parity, it is prudent to understand that the burger methodology exhibits plaguing limitations (Dewhurst, 2008). In numerous countries, having a meal at global fast food restaurant chains including McDonalds is expensive compared to having a meal in a local restaurant. Furthermore, the Big Mac demand is not as high in countries such as China compared to the United States. The social status associated with having a meal at a fast food restaurant chains in a local market, the proportional sales to expatriates, levels of competition, local taxes, and import duties may not represent the economy of the country as a whole.

Furthermore, no theoretical reason has been put in place to explain the equal prices of non-tradable products in different countries. This the theoretical reason for the differing purchasing power parity from rates of market exchange over time. Regarding the high margin goods and services relative cost; such as pharmaceutical products can compare the local willingness and capacity to pay similar to relative currency values (Dewhurst, 2008). Regardless, McDonalds employs different commercial strategies capable of leading to massive differences for the product. Overall, the purchasing the Big Mac price serves as a reflection of the delivery cost, local production, advertising cost, and most importantly, the bearing of the local market. This is distinct in every country and does not reflect the relative country values.

In certain markets, the low margin and high volume approach makes sense with its intent of maximizing profit. On the other hand, other markets employ the higher margin approach for the generation of more profits. Therefore, the relative product costs offer more reflection compared to the currency values. For example, the Bid Mac may cost €2 in Germany and €2.50 in Britain. However, the McDonalds restaurants in Britain are cheaper. The Big Mac price may as well vary between different regions of the same country. For example, the Big Mac price in Illinois is more expensive compared to that retailed in a more remote part of the neighboring state.

Risk Management

The difference between the prices of a product in one country compared to the landed cost in another is referred to as the differential grey market. If the differential grey market exhibits a positive rate, then this implies that the landed cost from the other country is lower compared to the price of the product from in the serving country. In this case, the Big Mac index uses this premise to purchase product materials internationally as a means of incurring fewer costs for the product compared to if it was purchased in the serving country. This therefore, serves to manage the risk of incurring extra costs by increasing overall profits.

Comparison Considerations

The Big Mac, as well as all McDonald sandwiches, has varying prices depending on the country’s nutritional values, nominal size and weight difference. Furthermore, not all Big Macs offered on sale are exclusively beef. For example, McDonald outlets in India do not sell beef burgers because the Hindu religion does not allow beef consumption. The Chicken Maharaja Mac substitutes the Big Mac. Considerably, there is significant variance coming from the beef Big Mac. For example, the version in Australia has 30% less energy compared to the beef Big Mac in Canada and 10% lighter than that in Mexico. In September 2009, a report was released stating that McDonald restaurants in Iceland were subject to closure due to the high importing costs on vegetables and meat from the European region. The Big Mac index maintains that the product of differential grey market and demand volume in a given country reflects the amount of risked profit (Maesepp, 2009).

References

Clements, K. W., Lan, Y., & Seah, S. P. (2012). The big mac index two decades on: An evaluation of burgernomics. International Journal of Finance and Economics, 17, 1, 31-60.

Dewhurst, W. A. (2008). An examination of the Big Mac index and its usefulness in empirical tests of the theory of purchasing power parity.

Maesepp, M. N. (2009). Purchasing Price Parity. Economic Papers: a Journal of Applied Economics and Policy, 28, 2, 169-175.