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A Prism into the PPP Puzzles: The Micro-foundations of Big Mac Real Exchange Rates

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  • David C. Parsley
  • Shang-Jin Wei

Abstract

The real exchange rate (RER) has been called the single most important price, yet its behavior exhibits several puzzles. In this project, we use Big Mac prices as a unique prism to study the movement of real exchange rates. Part of our innovation is to match these prices to the prices of individual ingredients. There are a number of advantages associated with our approach. First, unlike the CPI RER, we can measure the Big Mac RER in levels. Second, unlike the CPI RER, for which the attribution to tradable and non-tradable components involves assumptions on the weights and the functional form, we (almost) know the exact composition of a Big Mac, and can estimate the tradable and non-tradable components relatively precisely. Third, we can study the dynamics of the RER in a setting free of: the product-aggregation bias, the temporal aggregation bias, and the bias generated by non-compatible consumption baskets across countries. Fourth that Engel's result that deviations from the law of one price are sole explanation for RER movements does not hold generally. We offer some evidence that departure from the Engel effect can be systematically linked to economic factors.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10074.

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Date of creation: Nov 2003
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Handle: RePEc:nbr:nberwo:10074

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  1. Rudiger Dornbusch, 1990. "Real Exchange Rates and Macroeconomics: A Selective Survey," NBER Working Papers 2775, National Bureau of Economic Research, Inc.
  2. Paul G. J. O'Connell & Shang-Jin Wei, 1997. ""The Bigger They Are, The Harder They Fall": How Price Differences Across U.S. Cities Are Arbitraged," NBER Working Papers 6089, National Bureau of Economic Research, Inc.
  3. Engel, C., 1996. "Accounting for U.S. Real Exchange Rate Changes," Discussion Papers in Economics at the University of Washington 96-02, Department of Economics at the University of Washington.
  4. O'Connell, P. G. J., 1998. "Market frictions and real exchange rates1," Journal of International Money and Finance, Elsevier, vol. 17(1), pages 71-95, February.
  5. Jean Imbs & Haroon Mumtaz & Morton O. Ravn & Helene Rey, 2002. "PPP Strikes Back: Aggregation and the Real Exchange Rate," NBER Working Papers 9372, National Bureau of Economic Research, Inc.
  6. Chari, V V & Kehoe, Patrick J & McGrattan, Ellen R, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Wiley Blackwell, vol. 69(3), pages 533-63, July.
  7. Froot, Kenneth A. & Rogoff, Kenneth, 1995. "Perspectives on PPP and long-run real exchange rates," Handbook of International Economics, in: G. M. Grossman & K. Rogoff (ed.), Handbook of International Economics, edition 1, volume 3, chapter 32, pages 1647-1688 Elsevier.
  8. Matthias Lutz, 2002. "Beyond Burgernomics and MacParity: Exchange Rate Forecasts Based on the Law of One Price," 10th International Conference on Panel Data, Berlin, July 5-6, 2002 D4-1, International Conferences on Panel Data.
  9. Kenneth A. Froot & Kenneth Rogoff, 1991. "The EMS, the EMU, and the Transition to a Common Currency," NBER Chapters, in: NBER Macroeconomics Annual 1991, Volume 6, pages 269-328 National Bureau of Economic Research, Inc.
  10. V. V Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2002. "Can Sticky Price Models Generate Volatile and Persistent Real Exchange Rates?," Review of Economic Studies, Oxford University Press, vol. 69(3), pages 533-563.
  11. Click, Reid W., 1996. "Contrarian MacParity," Economics Letters, Elsevier, vol. 53(2), pages 209-212, November.
  12. Enrique G. Mendoza, 2000. "On the Instability of Variance Decompositions of the Real Exchange Rate across Exchange-Rate-Regimes: Evidence from Mexico and the United States," NBER Working Papers 7768, National Bureau of Economic Research, Inc.
  13. Puumanen, Kari, 1989. " Real Exchange Rates and Macroeconomics: A Selective Survey," Scandinavian Journal of Economics, Wiley Blackwell, vol. 91(2), pages 433-34.
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