At least once a year The Economist publishes its ‘hamburger standard’ exchange rates for currencies. It is a light-hearted attempt to see if currencies are exchanging at their purchasing-power parity rates. The test is the price at which a ‘Big Mac’ McDonald’s hamburger sells in different countries!
According to this simplified version of the purchasing-power parity theory, exchange rates should adjust so that a Big Mac costs the same in dollars everywhere (see Economics 8th edition Box 25.4).
These Big Mac exchange rates can be used to compare various prices and incomes between countries. The article linked below from The Guardian compares minimum wages between European countries in Big Mac terms.
There are 25 countries across Europe which have minimum wages. A clear pattern of minimum wage rates can be seen: although actual exchange rates understate the purchasing power of incomes in poorer European countries compared to richer ones, minimum wages, even in purchasing-power standard terms, are still higher in the richer countries.
Luxembourg’s minimum wage buys you just about three Big Macs in an hour, while most of northern Europe (and France) between 2–2.5 Big Macs. Moving south, the minimum wage nets about one Big Mac an hour. As we progress east, it begins to cost more than an hour of work on the minimum wage in order to afford a Big Mac.
Of course, there are other factors determining the dollar price of a Big Mac other than the failure of exchange rates to reflect purchasing-power parities. Nevertheless, using the Big Mac index in this way does give a useful preliminary snap shot of differences in what minimum wages can buy in different countries.
What is meant by ‘purchasing-power parity exchange rates’?
Why may actual exchange rates not accurately reflect the purchasing power of currencies within countries?
Using the link to Eurostat article above, compare Big Mac minimum wages with (a) actual minimum wages and (b) minimum wages expressed in purchasing-power standard terms.
Using the links to the Eurostat article and Eurostat data, describe how the proportion of employees earning minimum wages varies across European countries. What factors determine this proportion?
Using the same links, describe how the monthly minimum wage as a proportion of average monthly earnings varies across European countries. Explain these differences.
In August 2012, the ECB president, Mario Draghi, said that the ECB would ‘do whatever it takes‘ to hold the single currency together and support the weaker economies, such as Greece, Portugal and Spain. At the same time, he announced the introduction of outright monetary purchases (OMTs), which would involve purchasing eurozone countries’ bonds in the secondary markets. There were no limits specified to such purchases, but they would be sterilised by the sale of other assets. In other words, they would not increase the eurozone money supply. But despite the fanfare when OMTs were announced, they have never been used.
Today, the eurozone economy is struggling to grow. The average annual growth rate across the eurozone is a mere 0.5%, albeit up from the negative rates up to 2013 Q3. GDP is still over 2% below the peak in 2008. Inflation is currently standing at 0.8%, well below the 2% target. The ECB’s interest rate (‘main refinancing operations rate’) is 0.25%.
The recovery is hindered by a strong euro. As the chart shows, the euro has been appreciating against the dollar. The euro exchange rate index has also been rising. This has made it harder for the eurozone countries to export.
So what can the ECB do to stimulate the eurozone economy? Other central banks, such as the Bank of England, the US Federal Reserve and the Bank of Japan have all had substantial programmes of quantitative easing. The ECB has not. Perhaps OMTs could be used without sterilisation. The problem here is that there are no eurozone bonds issued by the ECB and hence none that could be purchased, only the bonds of individual member countries. Buying bonds of weaker countries in the eurozone would be seen as favouring these countries and might create a moral hazard.
Reducing interest rates is hardly an option given that they are at virtually zero already. And expansionary fiscal policy in the weaker countries has been ruled out by having to stick to the bailout conditions for these countries, which require the pursuit of austerity policies.
One possibility would be to intervene in the foreign currency market by buying US and other countries’ bonds. This would drive down the euro and provide a stimulus to exports. This option is considered in the Jeffrey Frankel article.
According to latest evidence from the Bank for International Settlements, in April 2013 some £3.2 trillion ($5.3 trillion) of foreign exchange was traded daily on global foreign exchange (forex) markets. About 40% of forex dealing goes through trading rooms in London. This market is highly profitable for the UK economy. But all is not well with the way people trade. There is a scandal about rate fixing.
Exchange rates on the forex market are freely determined by demand and supply and fluctuate second by second, 24 hours a day, except for weekends. Nevertheless, once a day rates are fixed for certain trades. At 4pm GMT a set of reference rates is set for corporate customers by banks and other traders. The rates are set at the free market average over the one minute from 16:00 to 16:01. The allegation is that banks have been colluding, through text messaging and chat rooms, to manipulate the market over that one minute.
Since the early summer of 2013, the Financial Conduct Authority (FCA) in the UK, along with counterparts in the USA, Switzerland, Hong Kong and elsewhere, has been looking into these allegations. Last week (4/3/14), the Bank of England suspended a member of its staff as part of its own investigation into potential rigging of the foreign exchange market. The allegation is not that the staff member(s) were involved in the rigging but that they might have known about it.The Bank said that, “An oversight committee will lead further investigations into whether bank officials were involved in forex market manipulation or were aware of manipulation, or at least the potential for such manipulation.”
Meanwhile, the House of Commons Treasury Select Committee has been questioning Bank of England staff, including the governor, Mark Carney, about the scandal. Speaking to the Committee, Martin Wheatley, head of the FCA said that the investigation over rigging had been extended to 10 banks and that the allegations are every bit as bad as they have been with Libor.
World markets were taken by surprise by a large rise in Turkish interest rates on 28/1/14. In an attempt to combat a falling lira and rising inflation, the Turkish central bank raised its overnight lending rate from 7.75% to 12%. Following the decision, the lira appreciated by over 3%.
Since the start of this year, the Turkish lira had depreciated by 7.1% and since the start of 2013 by 22.8%. Along with the currencies of several other emerging economies, such as India and Brazil, speculators had been selling the Turkish currency. This has been triggered by worries that the Fed’s tapering off its quantitative easing programme would lead to a fall, and perhaps reversal, of the inflow of finance into these countries; in the worst-case scenario it could lead to substantial capital flight.
Consumer price inflation in Turkey is currently 7.4%, up from 6.2% a year ago. The central bank, in a statement issued alongside the interest rate rise, said that it would continue with a tight monetary policy until the inflation outlook showed a clear improvement.
The Turkish Prime Minister, Tayyip Erdogan, has been opposed to rises in interest rates, fearing that the dampening effect on aggregate demand would reduce economic growth, which, as the chart shows, has been recovering recently (click here for a PowerPoint of the chart). A slowing of growth could damage his prospects in forthcoming elections.
World stock markets, however, rallied on the news, seeing the rise in interest rates as a symbolic step in emerging countries stemming outflows of capital.
Why did the Turkish central bank decide to raise interest rates by such a large amount?
Why has the Turkish lira been depreciating so much over the past few months? How has this been linked to changes in Turkey’s balance of payments and what parts of the balance of payments account have been affected?
Why did global stock markets rally on the news from Turkey?
What will be the impact of the central bank’s actions on (a) inflation; (b) economic growth?
How has the USA’s quantitative easing programme affected developing countries?
When the rest of the developed world went into recession after the financial crisis of 2007/8, the Australian economy kept growing, albeit at a slightly lower rate (see chart 1: click here for a PowerPoint). Then as the world economy began to grow again after 2009, Australian grow accelerated. Partly this was the result of a strong growth in demand for Australian mineral exports, such as coal, iron ore and bauxite, especially from China and other east Asian countries.
But in 2013, Australian growth slowed and jobs grew by their lowest rate for 17 years. Employment actually fell by 22,600 in December and unemployment was only prevented from rising by a fall in the participation rate. The Australian dollar, which has been depreciating in recent months, fell further on the news about jobs, reaching its lowest level for over two years (see chart 2: click here for a PowerPoint).
Chart 1 Chart 2
The following articles look at the reasons behind Australia’s slowing growth and at possible reactions of the Australian government and the Reserve Bank of Australia (Australia’s central bank). They also look at the link between economic performance and policy on the one hand and the exchange rate on the other.
Why has the Australian dollar been depreciating in recent months?
Why did the Australian dollar fall further on the news that economic growth had slowed and employment had fallen?
Find out what has been happening to commodity prices in the past three years (see Economic Data freely available online and especially site 26) How has this affected (a) the current account of Australia’s balance of payments; (b) the exchange rate of the Australian dollar?
If commodity prices are in US dollars, how is a depreciation of the Australian dollar likely to affect Australia’s balance of payments?
How are possible fiscal and monetary responses in Australia likely to affect the exchange rate of the Australian dollar?
What determines the magnitude of the rise or fall in demand for Australian exports as the world economy grows or declines? How are the determinants of the price and income elasticities of demand for Australian exports relevant to your answer?
At least once a year The Economist publishes its ‘hamburger standard’ exchange rates for currencies. It is a light-hearted attempt to see if currencies are exchanging at their purchasing-power parity rates. The test is the price at which a ‘Big Mac’ McDonald’s hamburger sells in different countries!
