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The Micro-foundations of Big Mac Real Exchange Rates

  • David C. Parsley

    ()

    (Vanderbilt University)

  • Shang-Jin Wei

    ()

    (International Monetary Fund Brookings Institution)

The real exchange rate is said to be the single most important price in an economy. While we used to think that we knew what explained its movements (e.g., the Balassa-Samuelson effect), the recent much-cited result by Engel (1999) proposes a serious reinterpretation – i.e., nearly 100% of the movements in the U.S. real exchange rate are explained by deviations from the law of one price. Engel’s finding holds even in the medium run, when movements in the relative price of non-tradables between countries, were thought to be of paramount importance. In this project, we study the movement of real exchange rates based on the prices of Big Macs (which we show are highly correlated with the CPIbased real exchange rates). Our main innovation is to match these prices to the prices of individual ingredients (ground beef, bread, lettuce, labor cost, rent, etc.) in 34 countries during 1990–2002. There are a number of advantages associated with our approach. First, unlike the CPI real exchange rate, we can measure the Big Mac real exchange rate in levels in an economically meaningful way. Second, unlike the CPI real exchange rate 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 real exchange rate in a setting that is free of the productaggregation bias (argued by Imbs, Mumtaz, Ravn, and Rey, 2002, to be important in studies on CPI real exchange rates), the temporal aggregation bias (argued to be important by Taylor, 2001), or the bias generated by non-compatible consumption baskets across countries. Fourth, we show that Engel's result that deviation from the law of one price is all that matters does not hold generally. Furthermore, deviations from his result can be systematically explained.

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Paper provided by Institute of Economics, Centre for Economic and Regional Studies, Hungarian Academy of Sciences in its series IEHAS Discussion Papers with number 0306.

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Length: 48 pages
Date of creation: Jun 2003
Date of revision:
Handle: RePEc:has:discpr:0306
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  1. David Parsley, 2002. "Accounting for Real Exchange Rate Changes in East Asia," International Finance 0211003, EconWPA.
  2. 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.
  3. Charles Engel, 1995. "Accounting for U.S. Real Exchange Rate Changes," NBER Working Papers 5394, National Bureau of Economic Research, Inc.
  4. 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.
  5. 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.
  6. 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.
  7. Charles Engel & John H. Rogers, 1995. "How wide is the border?," Research Working Paper 95-09, Federal Reserve Bank of Kansas City.
  8. Kenneth Rogoff, 1996. "The Purchasing Power Parity Puzzle," Journal of Economic Literature, American Economic Association, vol. 34(2), pages 647-668, June.
  9. David C. Parsley & Shang-Jin Wei, 2000. "Explaining the Border Effect: The Role of Exchange Rate Variability, Shipping Costs, and Geography," NBER Working Papers 7836, National Bureau of Economic Research, Inc.
  10. Puumanen, Kari, 1989. " Real Exchange Rates and Macroeconomics: A Selective Survey," Scandinavian Journal of Economics, Wiley Blackwell, vol. 91(2), pages 433-34.
  11. Dornbusch, Rudiger, 1989. " Real Exchange Rates and Macroeconomics: A Selective Survey," Scandinavian Journal of Economics, Wiley Blackwell, vol. 91(2), pages 401-32.
  12. Parsley, David C & Wei, Shang-Jin, 1996. "Convergence to the Law of One Price without Trade Barriers or Currency Fluctuations," The Quarterly Journal of Economics, MIT Press, vol. 111(4), pages 1211-36, November.
  13. Rose, Andrew K, 1999. "One Money, One Market: Estimating the Effect of Common Currencies on Trade," CEPR Discussion Papers 2329, C.E.P.R. Discussion Papers.
  14. 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.
  15. Ong, Li Lian, 1997. "Burgernomics: the economics of the Big Mac standard," Journal of International Money and Finance, Elsevier, vol. 16(6), pages 865-878, December.
  16. Michael R. Pakko & Patricia S. Pollard, 1996. "For here or to go? Purchasing power parity and the Big Mac," Review, Federal Reserve Bank of St. Louis, issue Jan, pages 3-22.
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