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May 1, 2006
2006 - Lesson #27 - Exchange Rates and "Burgernomics"
Please have Chapter 9, "Keping Score," from Naked Economics read for Wednesday's class.
Last time it was trade. This time it's money. More specifically, we'll look at international currencies and the role they play in the world's economy. Here are some definitions that you will need to understand:
Exchange Rates: The value of currencies worldwide is provided by exchange rates, which tell you what each currency is worth in relation to other currencies. In simple terms, a currency is worth what people will pay for it. Exchange rates are constantly adjusted to reflect markets.
* Fixed exchange rates: After the 1930s, most countries abandoned the gold standard. Instead, each country's government "fixed" the value of their currency, deciding what it would be worth. (For example, the British decided to exchange their pound into US dollars at a rate of $2.40 per pound.)
* Floating exchange rates: After 1973, international agreements on fixed rates expired, and currencies began to have their value decided in the market. A currency's value will "float" up or down. (An estimated $1.5 trillion dollars in currencies are traded every day in the world's foregin exchange markets.)
Purchasing Power refers to what money can actually buy in each country- calculating its purchasing "power". Purchasing Power Parity (PPP) would be when a currency can buy the same basket of whatever in any country.
"Burgernomics" is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country." (The Economist) In this case, the "basket" is simply a BigMac.
Playing with "Purchasing Power Parity (PPP): I think you'll like this stuff...
To do the following, you need a copy of "cross currency" rates. You can get one from the Benchmark Currency Rates page at Bloomberg.com. (Yes, that's the same Bloomberg as in the Mayor of New York City.)
Economists refer to purchasing power parity to describe why, over time, the dollar price of a good in one country should equal its dollar price in all other countries. The notion that a particular type of cordless telephone should sell for the same dollar price in the United States as it does in, say, Japan and Great Britain, makes sense if you think about supply and demand in world markets. Suppose that the telephone sells for $29.99 in the United States, 2500 yen in Japan, and 25 pounds in Great Britain.
Let's figure out in which country the dollar price of the cordless phone is lowest?
1. What is the exchange rate between the Japanese yen and the United States dollar?
2. What is the exchange rate between the British pound and the United States dollar?
3. Calculate the dollar price of the cordless phone in Great Britain.
4. Calculate the dollar price of the cordless phone in Japan.
5. In which country is the dollar price of the cordless phone the lowest?
6. In which country is the dollar price of the cordless phone the highest?
So, what does "purchasing power parity" suggest that an entrepreneur could do to earn profits?
Of course, purchasing power parity theory suggests that price adjustment will continue until the dollar price of cordless phones is the same in each country. This price equalization is an example of purchasing power parity. Note that it works best for close substitutes that can be traded among countries over long periods of time.
The "BigMac" Index: I did this exact same activity eighteen years ago in high school economics, but I didn't have a fancy laptop to make it easier... The Economist attempts to compare various currencies by using the "Big Mac" as the basis for consideration. The easiest way to make sense of this is to actually read their article and try the activity.
"Food for Thought": The Economist, May 27, 2004
This is, I believe, still their most recent full version of "Burgernomics". (Here is a snapshot of December 2004 data.) You need to read through the article to get a feel for how the concept works. After that, we can try a couple things. (I am bummed. They've removed data, so we can't do the computations ourselves. Ahh, progress.)
Here's another recent effort: The Starbucks index -Burgers or beans? The Economist, January 15, 2004
Coca-Cola map: If you liked the BigMac stuff, here is another one. Read the short article and examine the charts. What conclusions can you draw?
Foreign Exchange map: This is another service from The Economist. Once you get to the page, you have to "Launch the Map". Give it a minute or so to load itself. After that, follow the directions from the first page. Try several comparisons between countries and over time periods.
Posted by mvergin at May 1, 2006 3:32 PM