Exchange Rate Mechanism Paper

Global Financing and Rate Mechanisms Paper

Purchasing Power Parity

Onofre Castaсeda

University of Phoenix

Jose L. Hernandez

MGT/448: Global Business Strategies

May 06,2006

Purchasing power parity, or PPP, is a mechanism used to calculate an alternative exchange rate between the currencies of two countries. The PPP is an international measure of how much a currency can buy, since goods and services have different prices in some countries than in others.

PPP exchange rates are used to compare standards of living internationally. A country's GDP is originally tallied in its local currency, so any comparison between two countries requires a currency conversion. Comparing real exchange rates does not reflect price differences between companies, so they are considered unrealistic. However, the differences between PPP and real exchange rates can be significant. For example, GDP per capita in China is about US $1,400, while using PPP it is about US $6,200. At the other end of the spectrum, Japan has a nominal GDP per capita of about US $37,600, but its PPP figure is only US $31,400.

An information way of measuring the PPP between two currencies is the Big Mac index. The Economist newspaper introduced the Big Mac index in September 1986 as a humorous approach to help people understand purchasing power parity. The index also gave rise to the word Burgernomics.

In January 2004, The Economist introduced a sister to the Big Mac index: the Tall Latte index. While the idea is still the same, the Big Mac is replaced by a cup of Starbucks coffee. And it just so happens that the average price of a Starbucks tall latte in America is the same as the average price of a Big Mac, $2.80. By dividing the local currency price in each country by the dollar price we can calculate dollar PPPs. The PPP is then compared with actual exchange rates to test whether a currency is under- or overvalued.

The Tall Latte index tells the same story as the Big Mac index for most main currencies. Based on the average latte prices, the euro is about 30% overvalued against the dollar. Sterling is 17% too strong. Both measurements indicate the Swiss franc is the world's most overvalued