Question

4. The Economist publishes annually the ”hamburger standard” by which they compare the prices of the McDonalds Corporation Big Mac hamburger around the world. The index estimates the exchange rates for currencies based on the assumption that the burgers in question are the same across the world and therefore, the price should be the same. A Big Mac costs USD2.54 in the United States and JPY294 in Japan. The current exchange rate is 124 Japanese yen per U.S. dollar.
(a) What is the real exchange rate between the USD and the JPY?

(b) What is the PPP-implied exchange rate as hypothesized by the Hamburger index?

(c) Is the Big Mac hamburger in Japan correctly priced, undervalued or overvalued? By what percentage

Answer 1

Solution:-

(a)

Real exchange rate= Nominal exchange rate*(Price in foreign currency)/(Price in domestic currency) = 124*2.54/294 = 1.0713
Therefor, the real exchange rate is 1.07129.

(b)

PPP-implied exchange rate= Price in foreign currency/Price in domestic currency = 294/2.54= Yen 115.75 per dollar

(c)

As we can see that the prices of hamburger are not at PPP levels in the US and Japan.

Yen price of BigMac in Japan= Yen 294

Price of BigMac in US (In terms of Yen)= USD2.54*exchange rate = USD2.54*124= 314.96

Thus, the burger is underpriced in Japan clearly and the % is calculated as below:

Undervaluation of BigMac in Japan= (314.96-294)/314.96 = 6.65%

Therefore, BigMac is undervalued in Japan by 6.65%.