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The Micro-foundations of Big Mac Real Exchange Rates

Author

Listed:
  • David C. Parsley

    (Vanderbilt University)

  • Shang-Jin Wei

    (International Monetary Fund Brookings Institution)

Abstract

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.

Suggested Citation

  • David C. Parsley & Shang-Jin Wei, 2003. "The Micro-foundations of Big Mac Real Exchange Rates," CERS-IE WORKING PAPERS 0306, Institute of Economics, Centre for Economic and Regional Studies.
  • Handle: RePEc:has:discpr:0306
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    File URL: http://econ.core.hu/doc/dp/dp/mtdp0306.pdf
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Ivanic, Maros & Martin, Will, 2010. "Promoting Global Agricultural Growth and Poverty Reduction," Conference papers 331944, Purdue University, Center for Global Trade Analysis, Global Trade Analysis Project.
    2. Michael Funke & Jörg Rahn, 2005. "Just How Undervalued is the Chinese Renminbi?," The World Economy, Wiley Blackwell, vol. 28(4), pages 465-489, April.
    3. Jeffrey Frankel & David Parsley & Shang-Jin Wei, 2012. "Slow Pass-through Around the World: A New Import for Developing Countries?," Open Economies Review, Springer, vol. 23(2), pages 213-251, April.
    4. Sergio Da Silva & Guilherme Moura & Sidney Caetano, 2004. "Big Mac parity, income, and trade," Economics Bulletin, AccessEcon, vol. 6(12), pages 1-8.
    5. Michael Funke & Jorg Rahn, 2004. "By How Much Is The Chinese Renminbi Undervalued?," Money Macro and Finance (MMF) Research Group Conference 2004 40, Money Macro and Finance Research Group.
    6. Clements, Kenneth W. & Lan, Yihui, 2010. "A new approach to forecasting exchange rates," Journal of International Money and Finance, Elsevier, vol. 29(7), pages 1424-1437, November.
    7. Xinhai Lu & Mingxu Bai & Bing Kuang & Danling Chen, 2021. "Unlocking the Relationship between Land Finance and Regional Integration," Land, MDPI, vol. 10(9), pages 1-17, August.
    8. Michael Funke & Jörg Rahn, 2005. "Just How Undervalued is the Chinese Renminbi?," The World Economy, Wiley Blackwell, vol. 28(4), pages 465-489, April.
    9. Thomas Mathä, 2009. "Regional Mc parity: do common pricing points reduce deviations from the law of one price?," Review of World Economics (Weltwirtschaftliches Archiv), Springer;Institut für Weltwirtschaft (Kiel Institute for the World Economy), vol. 145(1), pages 155-166, April.
    10. Yongjian E & Anthony Yanxiang Gu & Chau-Chen Yang, 2009. "Real Exchange Rate Behavior under Peg: Evidence from the Chinese RMB and Malaysian MYR," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 12(01), pages 141-158.
    11. Robertson, Raymond & Kumar, Anil & Dutkowsky, Donald H., 2009. "Purchasing Power Parity and aggregation bias for a developing country: The case of Mexico," Journal of Development Economics, Elsevier, vol. 90(2), pages 237-243, November.
    12. Jeffrey Frankel, 2005. "On the renminbi," CESifo Forum, ifo Institute - Leibniz Institute for Economic Research at the University of Munich, vol. 6(03), pages 16-21, October.
    13. repec:zbw:bofitp:2004_014 is not listed on IDEAS
    14. Kenneth W. Clements & Yihui Lan, 2005. "How Long is the Long Run? Evidence from the Foreign Exchange Market," Economics Discussion / Working Papers 05-03, The University of Western Australia, Department of Economics.
    15. Bussière, Matthieu & Ca' Zorzi, Michele & Chudik, Alexander & Dieppe, Alistair, 2010. "Methodological advances in the assessment of equilibrium exchange rates," Working Paper Series 1151, European Central Bank.

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    Keywords

    Real exchange rates; TAR models;

    JEL classification:

    • F31 - International Economics - - International Finance - - - Foreign Exchange

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