The Big Mac Index and What About China - Case Study Example

Case Study Question The Big Mac Index computed by The Economist magazine has consistently found the U.S. dollar to be undervalued against some currencies and overvalued against others. This finding seems to call for a rejection of the purchasing power parity theory. Explain why this index may not be a valid test of the theory. Purchasing power parity is one of the most well-known theories of the economics which helps people to understand the value of currency and at the same time compare the prices of various products across the countries.

The common interpretation of this theory is very simple and that states that the value of any particular good in one nation is equivalent to its value in other countries if one considers the same keeping in mind the concept of exchange rate of the currencies between those nations. But this is not always the case in real time. Big Mac Index, developed based on the prices of Big Mac in the USA and many other nations has proved that in various countries, the value of their currency is overrated compare to that of the USA where as in some other countries the currency is underrated in comparison to that of USA.

In short run, the concept of PPP is not valid for various goods and the main reasons are organizations those are trading those items have to consider costs such as transportation cost, various kind of taxes such as VAT or government tax, Non traded service, competition in the existing market, Inflation etc. Along with all these factors, organization also needs to consider cost of labour while finalizing the price of the same. If one considers the case of Big Mac, in the USA, the labour cost is $ 8 per hour where as in China; the labour cost is as low as $ 1 per hours, so the final price of the Big Mac is far lower than that of the USA.

So it is very clear that the PPP theory is not always applicable while comparing the price of various goods across the countries as there are number of others factors play an important role is deciding the price.Question 2: Why would China want its own currency to be undervalued relative to the U.S. dollar? How does China maintain an undervalued currency?Many countries allow their currencies to grow at a slower pace compare to that of US Dollar or Euro. During 2013, the exchange rate of RMB was at $ 0.16. From 2005 onwards, Chinese government started allowing their currency to grow in a modest rate and in following five years, that is during 2005-2010, the Yuan rose total 20% in value compared to that of the US Dollar.

The main reasons behind allowing the modest growth of the currency are: weaker exchange rates allows growth in the export as various countries like to purchase more goods from China; the economy of China is largely dependent on export-this undervalued currency helped the nation to increase its export and at the same time boost the economy of the country; Growth in the export manufacturing industry helps China to create more jobs in the country; applying more tax and import duty reducing the import volume so the people of China are more likely to purchase products produced in the country so that the market of all Chinese goods are growing both domestically as well as internationally.

By keeping their currency undervalues, China able to boost its export and at the same time able to strengthen their own economy and also created more jobs for the people of the country.Direct or Indirect Intervention of Government (specially the central Banks) helps countries to keep their currency undervalued compare to that of US Dollar or Pound. Generally Chinese government used to purchase more Dollars from the US government to keep the value of Dollar higher than that of Yuan. This is the easiest way to keep the local currency undervalued in comparison to foreign currency and as China has a huge trade surplus they can afford to adopt this process.

Strong Export valuation helps them to buy more Dollars from the open market so that they are able to keep the demand of Dollars very high and simultaneously push the price of the Dollars comparatively higher compare to that of Chinese Yuan. One of the most common indirect measures to keep the value of local currency down is to put a cap of the volume of foreign currency investment that the locals can do outside the home country. Countries like India are adopting this policy to keep their currency undervalued compare to that of Dollar or Pound.

Tax law regulations can also affect the valuation of the currency, for example if the UK government allows tax free deportation of the Great Britain Pound, they can boost the inflow of Pound and at the same time influence the exchange rates compare to other currencies. At the end, one must also consider that undervalued currency also has some problems and one major point of concern is the inflationary pressure which, like every other nation, China also needs to keep in mind.