Purchasing Power Put To The Test: It's Nanonomics

Sydney Morning Herald

Friday May 18, 2007

Steve Burrell

WHEN you chomp on a Big Mac, sip a Starbucks coffee or listen to your iPod, you're also holding in your hands a way to tell whether the Australian dollar should be going up or down. The emergence of global brands like these have not only homogenised people's consumption habits the world over but allowed clever-clogs economists to bring to the masses the joys of exchange rate theory.

They have used them to develop indices based on the theory of purchasing-power parity (PPP), which says exchange rates adjust so that a common basket of goods and services costs the same in different countries in terms of their own currencies.

The oldest and most famous of these is The Economist weekly's Big Mac Index, invented in 1986 as a simple and accessible way of calculating the over and undervaluation of currencies against the US dollar.

This "burgernomics" is based on the idea that the McDonald's staple of two all-beef patties, special sauce, lettuce, cheese, pickles and onions on a sesame seed bun is essentially the same the world over, whether bought in Times Square, Red Square or Bankstown Square.

What's more, these ingredients are sourced within each country (although I still think the special sauce is synthesised in a secret laboratory deep inside a mountain in Colorado and shipped across the world).

The Big Mac exchange rate between any two countries is found by dividing the burger's price in one country's currency by the local currency price in the other. This is then compared with the actual exchange rate to determine whether Country A's currency is under or overvalued.

In simple terms, if a Big Mac in Australia is cheaper than the US version when expressed in US dollars, then the Australian dollar is theoretically undervalued.

There have been other variations on this theme by The Economist as the tentacles of globalisation spread, including 2004's Tall Latte Index, in which a Starbucks coffee played the role of the Big Mac.

The burgerfication of exchange rate theory has its limitations. Local culinary preferences, taxes, tariffs and other factors affect demand for and the pricing of Big Macs in some countries.

The index - and PPP theory itself - also fails to reflect the reality that there is no reason why prices of goods and services that are not traded between countries (and non-traded factors like property costs) should be the same across borders.

Those bright sparks at the share trading service CommSec have come up with Australia's own measure, the iPod Index, which addresses one of these problems but has a few limitations of its own. The index, developed by Craig James, compares prices for the 2GB Nano - chosen because it is widely available and the same everywhere. As the economists put it, it is "tradable" and "homogeneous".

An iPod should broadly cost the same in every country. If there were substantial price differences customers would switch their purchases to other countries - especially when they can now buy easily online. So any differences (shipping costs aside) should indicate whether a currency is under or overvalued.

A key difference between the iPod and Big Mac indexes is that the burgers are the same everywhere but made locally, whereas the MP3 players are predominantly made in China and exported everywhere. So the iPod doesn't meet all the criteria of PPP theory, because freight costs vary and because, being centrally manufactured, it won't reflect changes in domestic costs. But it is tradable and so may provide a purer measure of a currency's "true" value, James argues.

The local $219 price (which hasn't moved despite this year's rise in the Australian dollar), compared with $US149 in the US, suggests an iPod exchange rate with the greenback of about 68 cents. This compares with an actual rate of a bit over 83 cents - suggesting an overvaluation of the $A of around 22 per cent.

But with prices of $3.45 here and $3.22 in the US, the Big Mac Index suggests the $A is undervalued by almost 11 per cent and that the actual exchange rate should be over 93 cents.

So the dollar should be going up. Or down. Well, I did say they were bit of fun, didn't I?