The true measure of a latté
The flush Mail & Guardian reader might not mind spending almost R40 in Angola on his or her favourite weekly newspaper, but he or she would get better value in Malawi, where the paper is only R12,96. In South Africa the M&G costs R14,90.
Looking at the purchasing power of different currencies can provide a more meaningful understanding of how they compare than the official exchange rate.
This idea is based on an economic theory that if there are perfect currency markets, the price of a basket of goods should be the same in every country.
There are many reasons, however, that currency markets might not be perfect. The value of a currency can be heavily affected by short-term capital flows and might not reflect the fundamentals of a domestic economy.
The South African rand, for example, tends to strengthen disproportionately when the gold price booms, and is, therefore, known as a commodity currency. Economists also say that the rand is a barometer for emerging market sentiment.
In these scenarios the rand appreciates not because the demand for South African goods has increased or because the country is able to produce goods at relatively lower prices. Rather factors exogenous to the domestic economy have intervened, interfering with the relationship between the rand as a price and the value of domestically produced goods.
The outcome is that even when the rand appreciates because of the rising gold price, the country might still run a trade deficit.
To overcome these problems with foreign exchange rates as a measure of currencies’ worth, analysts compare the purchasing power of different currencies.
In 1986 the Economist magazine launched the “Big Mac Index” to illustrate how currency exchange rates compare with purchasing power based on the price of a Big Mac burger at multinational fast-food giant McDonald’s.
It uses this to indicate whether a currency is over or under-valued relative to the dollar.
The February 2007 index shows that a Big Mac, which costs $3,22 in the United States, is the most expensive in Iceland at $8,20—the burger costs 508 kronur in the local currency.
Based on the exchange rate, one might expect a Big Mac in Iceland to cost about 200 kronur because the official exchange rate is 62 kronurs per US dollar.
The Big Mac index therefore suggests that the Icelandic kronur is overvalued by 155%.
The least expensive burger in the world can be bought for $1,44 in China. This translates into 11,03 yuan at the exchange rate of 7,66 yuan to the dollar. Based on the exchange rate, one would expect a burger to cost $24,67 in China. The index finds that the yuan is undervalued by 55%.
According to the index, the fact that a Big Mac will set you back R15,50 or $2,17 indicates that the South African rand is undervalued by 32,59%.
Updating the index, the Economist devised a “tall latté index” in 2004 based on the price of a tall café latté from coffee multinational Starbucks. A tall latté that costs $2,80 in the United States will lighten the wallet of a person in Switzerland by $4,54. A consumer could get two lattés for that price in Thailand, where each costs $1,93.
Economist Joshua Gans argues, however, that it might be appropriate to use a commodity that is more standard than a Big Mac to compare purchasing power across countries.
The price of a Big Mac might reflect differences in local production costs in different countries, such as the cheaper cost of beef in Australia than Japan, he argues. He developed the iTunes index because a single firm sets the price, arguing that cross-country differences are likely to reflect demand.
Gans found that there was sometimes a significant difference between his findings based on the cost of downloading a song on iTunes and the Big Mac index.
He found that iTunes songs were more expensive outside the US and Canada.
An iTunes song costs 1,69 Australian dollars or US$2,24 in Australia, whereas it costs $0,99 in the US.