Manoa Brown
Friday, May 3, 13
Principles of Macroeconomics
Exchange Rates
People, firms and nation exchange products for money and use the money to buy other products to pay for the use of resources. Within an economy, prices are stated in the domestic currency, such as US dollars to European euros. Buyers use their currency to purchase goods. International markets are different. Producers in other countries who export goods want to be paid in their own currencies so they can carry out transactions. As a result, a foreign exchange market develops where national currencies can be exchanged. Such markets serve the need of all international buyers and sellers. The equilibrium prices in these markets are called exchange rates. An exchange rate is the rate at which the currency of one nation is exchanged for the currency of another.
The foreign exchange market is the financial relationship between countries that makes it possible for international trade to be accomplished more efficiently than barter. Because each nation uses its own monetary unit, people in one country who want to purchase something in another country must exchange their own currency for the other to accommodate the transaction. Many travelers will research foreign exchange rates before purchasing cheap airline tickets or other means of travel to other countries. Depending on the destination, some travelers can benefit greatly from exchanging currencies .The foreign exchange market is where one nation's currency is traded for another.
On any given day approximately $1.5 trillion in foreign exchange is traded. By any standard, that's a lot. The figure dwarfs the value of daily global stock trading, it is almost 20% of the United States GDP and nearly the size of the U.S. federal budget for an entire fiscal year. Contrary to what many people think, most foreign exchange trading is not in currencies, per se. Rather, it is in the form of bank deposit balances. Also, a surprisingly small number of banks account for the bulk of the volume, and nearly 90% of all trades involve U.S. dollars.
It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries. For example, the average price of a Big Mac in America at the start of 2013 was $4.37; in China it was only $2.57 at market exchange rates. So the "raw" Big Mac index says that the Yuan was undervalued by 41% at that time. 
 

The purchasing power parity theory suggests that exchange rates tend to adjust so that a person will have the same purchasing power to buy goods and services in another country after the exchange that he/she had with his/her own money in the home market before the exchange. The theory is founded on the law of one price which states that a commodity like a loaf of bread will, in effect, be the same price any where in the world if markets operate efficiently. Thus, if bread costs $1.00 per loaf in the United States and 100 yen in Japan, then the exchange rate will move toward $1.00 = 100 yen (and 1 yen will equal $0.01). Applying this theory, one would predict that relatively high inflation in one country would cause its currency to depreciate in the long run. This theory seems to predict reasonably well if one confines the analysis to internationally traded commodities. It tends to be nearly useless if the market basket of goods and services used to measure the price level includes many that are not traded internationally. Housing, auto insurance, gasoline, haircuts, evening dining, video rentals, entertainment, and other local services are examples.
Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible. Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. For those who take their fast food more seriously, we have also calculated a gourmet version of the index.
Over the years the Economist Magazine has created, what they call, the Big Mac Index. This form of presenting all of this information makes it very easy to understand and read. For example, the Big Mac Index specifies how for insistence China back in 2007 was almost at 55% undervalued and only on the past year has that number risen slightly to a mere 45% undervalued. All this means is that you can buy a lot of burgers in China with US dollars. China has been one of those countries that have artificially kept the value of their currency low. What this has allowed china to do is increase their exports because it is all inexpensive. China has also been funding a third of the US government, due to the fact that they have all of this money, and the US needs help with the recent debt that it has put itself in.

Now lets specifically looking at a corporation such as McDonalds, who have been able to expand themselves globally over the past decade. McDonalds has been able to appeal to all corners of the globe with their vast varieties meals. The Big Mac, the iconic McDonalds burger, is an item on the menu that I want to pay specific attention to. As I mentioned before about purchasing power, a Big Mac in the US cost $4.33 while a Big Mac in Russia cost you only $2.29 or 75 roubles. The same goes for Brazil where a Big Mac will cost you about $5 or 10 reais. What this suggests is that the rouble is cheap and the real is alittle steap. The Economist magazine has constructed the BIG MAC INDEX, which compares the prices of Big Macs and converts the foreign prices to dollars to see which currencies are over-priced, and which are underpriced. There are a few statistics that I want to point out; for example, the Venezuelan bolivar has gone from 1% to 83% overvalued, which is the result of such high inflation in the country. With contrast of the British pound going from 14% overvalued to 8% undervalued due to its financial industry, a big chunk of the overall economy, was at the heart of the recent turmoil in 2008 and its biggest export market, the euro zone, was in a dreadful mess.