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What is the optimal exchange rate of a currency? One answer is that it is the rate that brings an economy's overall international payments into balance over time. Since countries generally do not allow fully fluctuating exchange rates, and rely instead on some variation of managed exchange rates around targeted bands, it is difficult to derive a direct measure to test the theory against actual exchange rate fluctuations. Short of such direct observation, one can use a proxy measure, which the English weekly, The Economist, began publishing as the "Big Mac" Currency Index a few years ago. The Big Mac Index is based on the notion that the McDonald's Big Mac hamburger has enough ingredients for a representative basket of goods that can be priced directly on a comparative basis in a large number of economies. By calculating the price of a Big Mac in U.S. dollars at the official rate of exchange, and comparing this dollar price against the U.S. domestic price of a Big Mac, one has a measure of the under- or over-valuation of a country's currency. If one then takes the actual exchange rate and divides it by the Purchasing Power Parity, or PPP ratio, one then derives a PPP estimate of a country's "true" foreign exchange rate, i.e., one that provides a uniform dollar price of the Big Mac. Tests on the Big Mac currency index have proven surprisingly robust in predicting future movements in international currencies. As appealing (or as tasteless) as the Big Mac Currency Index may seem, visiting teams from the IMF to a local Ministry of Finance do not base their foreign exchange rate recommendations on the basis of the Big Mac the team members just had for lunch. More accurate measures factor in the degree of trade dependence, a broader mix of goods and services, as well as time. See the references below for a brief guide to the literature. |
Selected References: Edwards, Sebastian. Real Exchange Rates, Devaluation and Adjustment. (Cambridge, MA.: MIT Press, 1989).
Frenkel, JacobA. and Morris Goldstein. 1986. "A Guide to Target Zones." Staff Papers 33:633-73 (Washington, D.C.: International Monetary Fund).
Goldstein, Morris, and Carmen Reinhart. Forecasting Financial Crises: Early Warning Signals for Emerging Markets. (Washngton, D.C.: Institute for International Economics, 1998).
McKinnon, Ronald I. 1993. "The Rules of the Game: Money in Historical Perspective." Journal of Economic Literature 31:1-44.
Officer, Lawrence. 1976. "The PPP Theory of Exchange Rates: A Review Article." IMF Staff Papers 23:1-60.
Rivera-Batiz, Francisco L., and Luis A. Rivera-Batiz. International Finance And Open Economy Macroeconomics, second edition. (New York: Macmillan Publishing Company, 1994).
Williamson, John. Estimating Equilibrium Exchange Rates. (Washington, D.C.: Institute for International Economics, September 1994).
Wren-Lewis, Simon "On the Analytical Foundations of the Fundamental Equilibrium Exchange Rate," in C.P. Hargeaves, ed., Macroeconomic Modeling of the Long Run (Aldershot, England: Edward Elgar, 1992), pp. 323-338.
Last Updated on 2/7/99
By Phillip LeBel
Email:
| LeBelp@mail.montclair.edu |
