The Long-Run Value of Currencies: A Big Mac Perspective
Purchasing Power Parity (PPP), the link between exchange rates and prices, is a fundamental building block of international finance, one which has been attracting increasing research interest during the past three decades. The Big Mac Index (BMI), invented by 'The Economist' magazine in 1986, has played a major role in popularising PPP and bringing its practical implications to the attention of financial markets. The aim of this paper is to derive long-run equilibrium values of currencies using the Big Mac data from 'The Economist' magazine. As there are only ten years of data available, we have to use a parsimonious approach to modelling the evolution of exchange rates. The stationarity of real exchange rates is tested using recently-developed panel unit root tests with modifications. Through Monte Carlo methods, we analyse the whole distribution of the estimated equilibrium exchange rates and derive the adjustment paths of actual rates into the future. The new approach we propose for equilibrium exchange rates seems to have a number of attractive features including its modest data requirements (Big Mac prices), the minimal economic structure on the problem and its simplicity. Interestingly, out estimate of the speed of adjustment of real exchange rates to shocks and of the equilibrium exchange rates are quite close to those of other studies using more complex methodologies.
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