A Prism Into the PPP Puzzles: The Micro-foundations of Big Mac Real Exchange Rate
Centre for Economic Policy Research, 2003 - Foreign exchange rates - 32 pages
The real exchange rate (RER) has been called the single most important price, yet its behavior exhibits several puzzles. In this project, we use Big Mac prices as a unique prism to study the movement of real exchange rates. Part of our innovation is to match these prices to the prices of individual ingredients. There are a number of advantages associated with our approach. First, unlike the CPI RER, we can measure the Big Mac RER in levels. Second, unlike the CPI RER, for which the attribution to tradable and non-tradable components involves assumptions on the weights and the functional form, we (almost) know the exact composition of a Big Mac, and can estimate the tradable and non-tradable components relatively precisely. Third, we can study the dynamics of the RER in a setting free of: the product-aggregation bias, the temporal aggregation bias, and the bias generated by non-compatible consumption baskets across countries. Fourth that Engel's result that deviations from the law of one price are sole explanation for RER movements does not hold generally. We offer some evidence that departure from the Engel effect can be systematically linked to economic factors.
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aggregate real exchange Apec Appendix Table arbitrage Asean attribution Over attribution Balassa-Samuelson effect Big Mac prices Big Mac real Cheese Lettuce Onions Contribution of Traded convergence Country Dummies yes Country fixed effects CPI real exchange CPI-based real exchange Daron Acemoglu data set definition of x-share Deviations to Big Dummies yes yes Economics Engel effect equation 7a Euro Exchange Rate Movements exchange rate volatility fixed effects yes given in equation Half-life ingredients inputs Kenneth Rogoff Lettuce Onions Bread levels of real Mac real exchange Macroeconomics Mendoza Mercosur Nafta Onions Bread Median Parsley Persistence Estimates price in traded price indexes price of non-tradables Purchasing Power Parity random effects estimator real exchange rates regression relative price reports the results Shang-Jin Wei Share in variance Sum Tariffs table presents results table reports tradable and non-tradable Traded Good Deviations U.S. dollar x-share given yes Country Dummies yes This table yes yes Country yes yes yes