Case Studies

CaseStudies

CaseStudy 19.1: The Big Mac Index

Q1.The Big Mac Index computed by TheEconomistmagazine has consistently found the U.S dollar to be undervaluedagainst some currencies and overvalued against others. This findingseems to call for a rejection of the purchasing power parity theory.Explain why this index may not be a valid test of the theory.

Bydefinition, the purchasing power parity (PPP) theory does not includemost goods trades across international borders. This is because, ifinternationally traded goods were to be included in the exchangerates and purchasing power discussions, other calculations would alsobe included. For example, transportation costs of the goods from onecountry to another, which are difficult to calculate. Furthermore,PPP theory is weak due to its practical application by U.S policies.These policies manipulate the strength of the US dollar by increasingAmerican exports. Further, PPP theory claims that exchange ratesshould equalise currencies for two countries for the sameinternationally traded goods. Different local price, local taxes, andtrade barriers affect the cost of the Big Macs. For this reason,McEachern(2012) urges that US dollar appears undervalued in some countries andover valued in others.

CaseStudy 19.2: What about China

Q1.Why would china want its own currency to be undervalued relative tothe US dollars? How does china maintain an undervalued currency?

Chinaprefers its own currency to be undervalued relative to US dollarbecause they believe it will promote export and growth, especially inexporting industries. Firstly, the Chinese growth is high comparedUS. China requires high rate of growth in order to absorb cheaplabour for their industries. China believe that without job creationin the manufacturing sector, they would end up facing social unrestand high unemployment rate. Therefore, undervalued currency will helpthem boost demand for their exports, as well as their services(McEachern,2012).China maintains its currency undervalued by buying the US currencyand treasury notes hence, keeping the demand for US dollar high.China is rich to buy and hold much of US currency since its conducthuge trade surplus with America. Therefore, it can also but the UScurrency equal to the surplus. To maintain the influx of dollars,china sterilizes the dollar purchase and sells bonds to theirinvestors.

References

McEachern,W. A. (2012). ECON Macro 3 (3rd ed.). Mason, OH: South-Western.