International Finance

Case study - 3
Anusha Datta
(1152190001)

One of the bases for international economics is the theory of purchasing

power parity , according to which price levels in any two countries must be
identical after converting the prices into a common currency . PPP has
served as the basis for theories of international price determination and also
the conditions under which international markets adjust to attaining long
term equilibrium . Baring a few exceptions , the component ingredients of
the big mac are the same around the globe . The foundation of PPP is the law
of one price which states that any good that is traded on world markets will
sell for the same price in every country engaged in trade , when prices are
expressed in a common currency . The case states Icelandic Krona as the
most overvalued currency . There are a few reasons for this -
● Iceland is probably "the world‘s most expensive country“
● Export sectors earnings are deteriorating fast
● The real exchange rate is probably above its equilibrium value
● Wages in Iceland are among the highest in the developed world

The chinese government chooses to keep its currency undervalued because -

● A weaker exchange rate increases demand for chinese exports and makes
them more competitive
● The economic growth of China is dependent on exports and therefore the
value of currency plays a huge role in boosting growth

However , the PPP does not hold very well in the short run . The deviations from
this theory are sometimes so large that it is dismissed by the economists . In that
case there are things about the exchange rate that the big mac would not be able to
tell us .
 The euro has remained overvalued and recently spiked amongst all major
currencies. As the chart shows, the euro has spiked against AUD and NZD most
significantly, while it has also strengthened measurably against the Canadian dollar
and U.S. dollar. This is most likely mainly due to the currency's recent popular
function as a funding currency. The case also mentions that a PPP transforms the
same rankings that are done on market exchange rate . Market exchange rates
balance the demand and supply for international currencies , while the PPP rates
capture the difference between cost of a given bundle of goods and services in
different countries . PPP is favoured as they have a closer link to welfare but
MERS are the basis for international trade so its a difficult choice . The PPP rates
are relatively stable overtime , while the market rates can be volatile . There is a
huge difference in the two estimates: the GDP goes up in case it is measured by the
PPP when compared to the calculation made at the weak market exchange rates.
Households are different in every country and so are prices therefore
exchange rates reflect the equalization of differences , domestic to foreign . The big
mac index only partly reflects price differences . The reason the index varies is
because cost of living is not the same everywhere and does not reflect demand as
much as supply . The index will definitely change if the measure is changed from a
burger to something else . In many countries dining at MCdonald’s is costlier
compared to local restaurants . Therefore the demand is relatively less , considering
that it might not be a global standard .