ee econ final

International Baccalaureate Economics Extended Essay St. Stephen’s School Rome

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IB ECONOMICS EXTENDED ESSAY

THE REVENGE OF THE BIG MAC INDEX

Does the Big Mac Index perform better after the Eurozone’s introduction of a common currency such as the Euro?

Session: May 2014 Candidate Name: Ascanio Rossini

Session Number: 000061-0051 IB Subject of Essay: Economics (HL)

Supervisor: Mr. Duncan Pringle Word Count: 3875


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Abstract

This essay explores how the transition to a large market with a single currency accounts for the cutback of all the trade and transaction costs that are directly associated to the existence of many, relatively small currency markets. The introduction of the Euro in 2002, has contributed to improving the integration and efficiency of currency markets by cutting bilateral transaction costs imposed on trade. To verify our hypothesis we will study how closely Purchasing Power Parity (PPP) adjusts to the monetary exchange rate, before and after the Euro. The indicator that will be used to determine whether exchange rates converge to their respective PPP’s will be the Big Mac Index. Hence the research question: Does the Big Mac Index perform better after the Eurozone’s introduction of a common currency such as the Euro? If transaction costs have disappeared with the establishment of a large market, then we are expecting PPP to forecast more accurately. To assess the validity of our hypothesis we have studied three small markets in the time frame 1992-2001 being France, Germany and Italy. Then we have compared their performances to that of a much larger market that encompasses all of the three after 2002, the Euro-market. For all of these we have calculated the deviation between monetary exchange rate and the PPP rate given by the Big Mac Index by taking their difference. The curves for each country’s PPP rate and monetary rate were plotted on a set of axes, allowing to examine their trends. The investigation found that indeed, the Big Mac Index performed better after the introduction of the Euro owing to the decline in transaction costs. Surprisingly however the ability of the Big Mac Index to forecast exchange rates was maximised in the time frame 1998-2001, as a result of the market’s expectations for a monetary union.

300 words


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Acknowledgments

I would like to thank my supervisor for the great patience and support in the writing process. Then I would like to thank Dr. Filippo Calciano for having encouraged me, and helped me understand a theoretical framework that goes beyond our course syllabus.


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Table of Contents Title Page ............................................................................................................................ 1 Abstract .............................................................................................................................. 2 Acknowledgements ............................................................................................................ 3 Table of Contents ............................................................................................................... 4 Chapter I: Introduction and Scope of Work ................................................................... 5

i. Scope of Work ......................................................................................................... 6

Chapter II: Theoretical Framework ................................................................................ 7 i. Law of One Price (LoOP) ........................................................................................ 8 ii. Transaction Costs, Asymmetries in Information and Barriers to Trade ................. 9

Chapter III: Methodology ............................................................................................... 10 Chapter IV: Data Collection and Analysis .................................................................... 11 Chapter V: Conclusion .................................................................................................... 18

i. Limitations of Investigation ................................................................................... 19 ii. Unresolved Questions and Further Analysis ......................................................... 19

Bibliography ..................................................................................................................... 20


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Chapter I: Introduction and Scope of Work People in every corner of the world are persistently attempting to forecast exchange rate movements for different purposes and causes. An investor in Germany studies the market to determine in which country will his investment be more profitable, a speculator in Spain plans to make money through the exchange rate system and a tourist in Russia considers if it will be cheaper to travel to Hungary or to Poland for his winter vacation. Yet the links between economic fundamentals and currency values have proved to be elusive1, and this compels the pursuit to seek the key in forecasting these values. Economists have, in effect, agreed that no models predict well, and as the International Monetary Fund (IMF) has observed, the real consensus in exchange rate economics is probably the difficulty of forecasting exchange rates, especially for short horizons (one year or less)2. In 1983 furthermore, the findings of economists Meese and Rogoff formally challenged the economic profession; observing that exchange-rate models based on fundamentals failed to outperform ‘random-walk’ models3. No models predict well, let alone the Big Mac Index, introduced by The Economist magazine in 1986 as a new tool to compare the extent to which currencies around the world are over- or under-valued with respect to the US Dollar. The index compares the prices of the McDonald’s Big Mac sandwich in various countries around the world, evaluating the prevailing exchange rates against international price differences4. The theoretical ground upon which the Big Mac Index is based is the theory of Purchasing Power Parity (PPP), which is nothing but the equilibrium value of currencies – the exchange rate towards which any two currencies will move over time until equating the cost of purchasing the same basket of goods in the two countries5. The Big Mac item is used to indicate how close are exchange rates to parity because it is the same in all countries, and it is almost a pure non-tradable6. An actively traded good like oil, would be a poor indicator of whether currencies are valued correctly as the Law of One Price holds without regard to whether the exchange rate is at purchasing power parity7. The Big Mac Index is therefore the ideal indicator for such measure.

1Wang, Jian. "Why Are Exchange Rates so Difficult to Predict?" EconomicLetters 3.6 (2008): 1-‐ 2International Organization. The International Monetary Fund. Research Department. IMF Working Paper. By David Hauner, Jaewoo Lee, and Hajime Takizawa. International Monetary Fund (IMF), May 2010. Web. 17 July 2013. <http://www.imf.org/external/pubs/ft/wp/2011/wp11116.pdf>. 3Meese, Richard A. and Rogoff, Kenneth, 1983. "Empirical exchange rate models of the Seventies : Do they fit out of sample?," Journal of International Economics, Elsevier, vol. 14(1-‐2), pages 3-‐24, February. 4The Big Mac™ is a registered trademark of the McDonalds Corporation. 5Ziogas, Constantine. "Purchasing Power Parity." Economics for the IB Diploma: Standard and Higher Level. Oxford: Oxford UP, 2008. Pg. 114 Print. 6 Dunn, Robert Jr. “Does the Big Mac Predict Exchange Rates?” Challenge, Vol. 50, No.3 (MAY-‐JUNE 2007), pp. 113-‐122. Published by M.E. Sharpe, Inc. 7 Ibid.


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i. Scope of Work On January 1st, 2002, eleven of the fifteen members of the European Union physically adopted a single currency, the Euro, and a few years before a common monetary policy regulated by the European Central Bank. According to the latter, the Euro boosted trade among the Eurozone as a result of the reduction in bilateral trade costs among Eurozone nations; a reduction, which entailed major cuts in transaction costs8. The creation of a single, large currency market for euro-using nations encouraged pricing transparency, making the third party arbitrage phenomenon safer. Our hypothesis in this work, that which will be assessed through data - is that the cuts in transaction costs brought by the implementation of the Euro have substantially improved the integration and the efficiency of the currency markets. This should tend to correct the condition of arbitrage on currencies, meaning that the exchange rates should adjust more closely to the Purchasing Power Parities. Our main tool to assess whether exchange rates converge more and more speedily towards their respective PPP will be nothing but the Big Mac Index. The aim of this essay is to verify if the transition to a large, single market with a sole currency results in the cutback of all those trade and transaction costs associated to the existence of many, relatively “small”, currency markets. This ultimately translates into validating if the Big Mac Index performed better in forecasting European exchange rates after, rather than before, the implementation of the Euro. Hence the research question; does the Big Mac Index perform better after the Eurozone’s introduction of a common currency such as the Euro? The measures of PPP provided by the indicator, will be compared to the actual monetary exchange rate, allowing to draw conclusions about the performance both in the short- and in the long-run. The investigation will be based on analysing the ability of the index to forecast the exchange rate before and after the Euro when we demand an instantaneous adjustment of the market to PPP, and on analysing the ability of it to forecast the exchange rate, before and after the Euro when we introduce a lag variable, that allows the currency market to adjust to parity in a wider time frame.

8 Di Nino, Virginia, and Lionel Fontagnè. "Executive Summary." Preface. Study on the Impact of the Euro on Trade and Foreign Direct Investment. By Richard E. Baldwin. Brussels, Belgium: European Commission, Directorate-‐General for Economic and Financial Affairs, 2008. 5. Print.


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Chapter II: Theoretical Framework Purchasing Power Parity can be though of as an extension of the Law of One Price, which states that identical goods must be sold at the same price in two different markets when their prices are expressed in a common currency. As an example, if stands for the price of a Good A in Euros (€), 𝑃!

$ stands for the price of exactly the same good but in Dollars ($), and e is the Euro/US Dollar exchange rate, then according to the Law of One Price the following equation should hold within a sufficiently small time-frame:

,

By rearranging terms, one gets

The left-hand-side ratio is the Purchasing Power Parity (PPP) rate; the rate towards which the monetary exchange rate e is expected to move over time. The above equation should be satisfied, at least in the long-run. When it fails, it is due to transaction costs (i.e. informational asymmetries, costs to access currency markets, import-export costs above those justified by trading operations, etc.) These costs should be reduced when the market becomes larger, as it has done in 2002 with the Euro.


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Purchasing Power Parity (PPP) theory works poorly when applied to real-world data9, whether it to be a price index or a collection of observations. The early efforts put into the application of the theory, established that it is very difficult for a PPP relationship to hold true between two countries at a given point. The theory’s poor performance is largely attributable to several assumptions, which are not likely to hold in the real-world economy . There are a number of ‘frictions’ such as tariffs, nontariff barriers, transportation costs, measurement problems10 that one must take into account when dealing with PPP theory.

i. Law of One Price (LoOP) The real value of a unit of currency must be the same in different countries, so as to achieve parity. PPP theory is founded upon an extension of the law of one price. The law of one price states that identical goods will sell for the same price in different markets when their prices are expressed in a common currency, assuming that there are no transportation costs and no differential taxes applied in the two markets. Consider the following information about sesame seeds – one of the basic ingredients of the Big Mac – in Italy (in euros) and in Britain (in pounds).

Price of sesame seeds in Italian market

Price of sesame seeds in British market

Spot exchange rate, euro/pound

,

if sesame seeds cost 3 per bushel in Britain ( ), and the euro/pound exchange rate (e) is equal to 0.7, then the law of one price states that the price of sesame seeds ( ) in Italy should be €2.1. The law holds only if the good is sold in an integrated market in which transportation costs, tariffs, trade barriers, subsidies and taxes are absent. If different prices prevailed, and sesame seeds would sell at price higher than €2.1, a profit-maker would buy the good in Britain and sell it in Italy generating an activity known as arbitrage. This condition devalues the exchange rate e, until the equilibrium described by the equation is satisfied. The market’s excess demand for the British pound (£) generated by arbitrage, drives the oscillating exchange rate to be equal to the ratio of the two prices.

9Suranovic, Steven M. “Chapter 6: Purchasing Power Parity.” International Trade:Theory and Policy. Irvington, NY: Flat World Knowledge, 2010. N. pag. Print. 10Ibid.


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iii. Trading Costs, Asymmetries in Information and Barriers to Trade There are many reasons behind the index’s systematic deviations from PPP. First, it is costly to trade goods across borders. Transportation costs, government-imposed trade barriers, and taxes all limit the extent to which differences in prices across countries will result in the international movement of goods14. Costs related to the transportation and the shipping of the good are likely to drive the prices for similar goods apart when traded in two different markets. The shipping of Big Mac components such as the beef, the cheese and the lettuce is costly, and certainly influence the country’s price scheme for the good. Secondly, asymmetries in information make currency markets non-perfectly competitive and, as such, the relative privet of two currencies – i.e. the monetary exchange rate – does not represents properly the economic fundamentals embodied in the PPP exchange rates. Another important factor that hinders parity is the existence of tariffs and other legal restrictions on trade. Nearly every country attempts to restrict the importations of foreign agricultural goods through the use of tariffs and quotas for the purpose of stimulating and protecting its domestic sector. While a tariff simply acts as a tax on the imported good, the quota limits the amount of goods that can be imported. Both of these trade restrictions raise the price of the imports, making the transaction more expensive. An additional factor that would explain why deviations from PPP occur, is the presence of taxes. The Big Mac prices reported in the index are inclusive of sales or value added taxes, which vary from country to country. Thus, ceteris paribus, all other things remaining equal, countries with higher taxes on a Big Mac relative to the United States would appear to have over-valued currencies relative to the dollar15. For the same reason, changes in a country’s tax rate on the good will account for apparent shifts in Big Mac parities.

14 Pakko, Michael R., and Patricia S. Pollard. "Burgernomics: A Big Mac™ Guide to Purchasing Power Parity." Economic Research. Federal Reserve Bank of St. Louis, 1 Nov. 2003. Web. 19 July 2013. <http://research.stlouisfed.org/publications/review/03/11/pakko.pdf>. 15 Ibid.


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Chapter III: Methodology In order to approach the investigation question, secondary data will be gathered and selected from the Economist’s Big Mac Index, which provides PPP measures that indicate the under or over-valuation of a currency compared/with regard to the US Dollar. To assess the validity of our hypothesis, the collected data will cover a time frame of twenty years; the first set (Figure 1) will include the ten-year period preceding the introduction of the Euro (1992-2001), and the ten years that follow the introduction of the currency (2002-2012). The former set will present figures for the countries; France, Germany and Italy, representing the relatively ‘small’ currency markets of the Eurozone up to 2002. The effects of the transition to a single currency on the index’s performance, with the formation of a European monetary union will be assessed in our second set (always in Figure 1) with the PPP figures for a much larger market; the Euro/Dollar. The currencies the investigation will deal with, are expressed and abbreviated as follows:

More importantly however, the mathematical criterion that will be employed to analyse and measure the deviation of PPP from the monetary exchange rate (erate) is the difference. To determine if the index performed, or forecasted better after the introduction of the Euro it is sufficient to take,

𝑒! − 𝑃!𝑃!

!

with the ratio of prices simply being the PPP rate, and 𝑡 being the variable time, the year. Furthermore, given that Purchasing Power Parity is the exchange rate towards which the currencies are expected to move over time, we will introduce a lag variable (two-period lag),

𝑒! − 𝑃!𝑃!

!!!

demanding the currency market’s adjustment to parity in a wider time frame, a delayed adjustment is a result of the variable. The differences are expressed in absolute value, as we are not concerned with drawing conclusions about whether a currency is under- or over-valued as indicated by the Big Mac Index. The calculations are presented in Figures 2-5.

US Dollar = USD French franc = F.

German Mark = DM. Italian Lira = L.

Euro Currency = €


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Chapter IV: Data Collection and Analysis Big Mac Index figures are presented for France, Germany and Italy starting from 1992 and leading up to 2001, before the transition to the Euro (€) currency. Subsequently to 2001, figures of the Dollar exchange rate and the implied PPP are given for the Euro Area. The data is provided by The Economist magazine16.

Figure 1: Big Mac Index, 1992-2011

Year Country Big Mac Price in local currency

Big Mac Price in Dollars (USD)

Actual /USD Exchange Rate

Implied PPP of the Dollar (USD)

1992 France 18,1 3,26 5,55 8,26 Germany 4,5 2,74 1,64 2,05

Italy 4100 3,33 1233 1872

1993 France 18,5 3,46 5,34 8,11

Germany 4,6 2,91 1,58 2,02 Italy 4500 2,95 1523 1974

1994 France 18,5 3,17 5,83 8,04

Germany 4,6 2,69 1,71 2

Italy 4550 2,77 1641 1978

1995 France 18,5 3,85 4,8 7,97 Germany 4,8 3,48 1,38 2,07

Italy 4500 2,64 1702 1940

1996 France 17,5 3,41 5,13 7,42

Germany 4,9 3,22 1,52 2,08 Italy 4500 2,90 1551 1907

1997 France 17,5 3,04 5,76 7,23

Germany 4,9 2,86 1,71 2,02

Italy 4600 2,73 1683 1901

1998 France 17,5 2,84 6,17 6,84 Germany 4,95 2,69 1,84 1,93

Italy 4500 2,47 1818 1758

1999 France 17,5 2,87 6,1 7,2

Germany 4,95 2,72 1,82 2,04 Italy 4500 2,5 1799 1852

16 "The Big Mac Index." The Economist. The Economist Newspaper, n.d. Web. 28 Sept. 2013. <http://www.economist.com/content/big-‐mac-‐index>.


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2000 France 18,5 2,62 7,07 7,37 Germany 4,99 2,37 2,11 1,99

Italy 4500 2,16 2088 1793

2001 France 18,5 2,49 7,44 7,28

Germany 5,1 2,30 2,22 2,01 Italy 4300 1,96 2195 1693

2002 Euro area 2,67 2,37 1,12 1,08

2003 Euro area 2,71 2,89 0,91 1,00

2004 Euro area 2,74 3,28 1,19 1,06

2005 Euro Area 2,92 3,58 1,22 1,05

2006 Euro Area 2.94 3,77 1,28 1,05

2007 Euro Area 2,94 3,82 1,30 1,10

2008 Euro Area 3,37 5,34 1,59 1,06

2009 Euro Area 3,31 4,62 1,39 1,08

2010 Euro Area 3,38 4,33 1,28 1,10

2011 Euro Area 3,44 4,93 1,43 1,18


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Figures 2-5: Processed Big Mac Index Processed data figures for each individual country show aside from the PPP rate and the US Dollar exchange rate also the difference adjusted instantaneously and adjusted to a lag variable (two-period lag).

Figure 2: France, 1992-2001

Figure 3: Germany, 1992-2001

Year (t) PPP rate^(t) erate^t USD/FR e^t -‐ PPP^(t) e^t -‐ PPP^(t-‐2)

1992 8,26 5,55 2,71 1993 8,11 5,34 2,77

1994 8,04 5,83 2,21 2,43 1995 7,97 4,80 3,17 3,31

1996 7,42 5,13 2,29 2,91

1997 7,23 5,76 1,47 2,21 1998 6,84 6,17 0,67 1,25

1999 7,20 6,10 1,10 1,13 2000 7,37 7,07 0,30 0,23

2001 7,28 7,44 0,16 0,24

Year PPP rate^(t) erate^(t) USD/MR e^(t) -‐ PPP^(t) e^(t) -‐ PPP^(t-‐2)

1992 2,05 1,64 0,41 1993 2,02 1,58 0,44

1994 2 1,71 0,29 0,34

1995 2,07 1,38 0,69 0,64

1996 2,08 1,52 0,56 0,48

1997 2,02 1,71 0,31 0,36

1998 1,93 1,84 0,09 0,24

1999 2,04 1,82 0,22 0,2

2000 1,99 2,11 0,12 0,18

2001 2,01 2,22 0,21 0,18


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Figure 4: Italy, 1992-2001

Year PPP rate^(t) erate^(t) USD/LIR e^(t) -‐ PPP^(t) e^(t) -‐ PPP^(t-‐2)

1992 1872 1233 639 1993 1974 1523 451 1994 1978 1641 337 231

1995 1940 1702 238 272 1996 1907 1551 356 427 1997 1901 1683 218 257 1998 1758 1818 60 89 1999 1852 1799 53 102 2000 1793 2088 295 330 2001 1693 2195 502 343

Figure 5: Euro Area, 2002-2012

Year PPP rate^(t) erate^(t) USD/€ e^(t) -‐ PPP^(t) e^(t) -‐ PPP^(t-‐2)

2002 1,08 1,12 0,05

2003 1,00 0,91 0,09

2004 1,06 1,19 0,13 0,11

2005 1,05 1,22 0,17 0,22

2006 1,05 1,28 0,23 0,22

2007 1,10 1,30 0,20 0,25

2008 1,06 1,59 0,53 0,54

2009 1,08 1,39 0,31 0,29

2010 1,10 1,28 0,18 0,22

2011 1,18 1,43 0,25 0,35


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Note*: in order for the the scatter plot to be appropriately scaled, fitting all data values, the data values for Germany were added 1,5 and the data values for Italy were all divided by 1000. Refer to Figure 1 for actual values and not directly to the graph. The graphical approach to the question, involves analysing the deviation that is present when the curves representing the PPP measure and the monetary exchange rate (erate) are plotted on the same set of axes as displayed above (Figure 7). The deviation is indicated by the vertical distance between the pair of curves for each country; with the curves being the PPP rate and the erate with respect to the US Dollar. We are expecting to see differences in the curves’ trends and tendencies as we move from the three small currency markets prior to 2002, to a large European currency market. The plotted values for the first set of data, which comprise Big Mac Index figures for France, Germany and Italy in the years 1992-2001, denote a clear difference between PPP and exchange rate before the introduction of the Euro. This difference entails that that there is a marked existence of transaction costs associated to trade that account for the discrepancy between the forecasted value (PPP), and the actual value of the currency. The Big Mac Index as a PPP indicator and hence also as tool that attempts to forecast exchange rates, performs rather poorly in the time frame 1992-2001. The deviation is particularly pronounced in the case of France until 1998, when the gap begins reducing and the two measures converge to one another, intersecting only in 2001. By observing the graph, the drop in the USD/F. erate between 1994 and 1995 to the point (1995, 4,80) is not followed also by a decrease in the PPP rate value, which stays at (1995, 7,97). It is in fact in the year 1995 that we observe the largest difference in PPP and erate for France, with 3,17. We cannot determine what has caused the substantial deviation for France between the years 1992-1995. Or better, it would

0,00

1,00

2,00

3,00

4,00

5,00

6,00

7,00

8,00

9,00

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

PPP France erate USD/F.

PPP Euro erate USD/€

PPP Italy erate USD/L.

PPP Germany erate USD/DM.

PPP, erate

Time (t)

Figure 7


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require examining the French central bank’s monetary policy in that stage, but it is not the essay’s focus. We can nevertheless observe from the trend in graph of Figure 1 that France appeared to have maintained an over-valued monetary exchange rate with respect to the PPP rate – if their exchange rate is in terms of a the quantity of Francs to purchase one US Dollar. The curves for Germany and Italy instead, show a very different trend with a deviation that is far less pronounced than that of Germany, but still noticeable. While France’s curves rapidly converge, these other ones appear to have a stable tendency maintaining the same deviation gap until their intersection. If we observe the graph for Germany in the years between 1992 and 1998 and compare it to the data values given in Figure 3 we see that the difference, spans between 0,09 and 0,69, a relatively narrow range. Similarly, Italy in turn, up to 1998 displays an evident deviation, with a difference that ranges between 218 and 639. The three countries we have looked at in the time frame 1992-2001 all display characteristics of small markets that act independently from others; countries that when trading goods (imports, exports) are imposed costs that prevent the PPP assumption from holding. However, it is interesting to observe and subsequently determine why do all of the curves present the same tendency behaviour starting from 1998. PPP rate and erate all appear to converge, reducing the gap created by trade costs, when moving towards the physical introduction of the Euro, in the period between 1998-2001. The year 1998 coincides in fact with succession of the European Central Bank (ECB) that settled the ground for the launch of the currency in 1999. The exchange rate markets have anticipated the effect that would have been brought by the physical introduction of the Euro in 2002, thereby reducing the deviation. The PPP rate began forecasting better and investors, which represent the driving force of the market, have counter-acted the change driving the exchange rate to be equal to the ratio of the two prices. To have a better understanding of this phenomenon, it is enough to think of how would one move on the USD/F. exchange rate if expecting the market to adjust to PPP. The market’s excess demand for the currency will move it towards satisfying the LoOP identity, for which identical goods must be sold for the same price in two different markets when their prices are expressed in a common currency. It is in this time frame (1998-2001) that we observe the closest adjustment of the exchange rates to parity, particularly for Germany and Italy. The curve for Germany shows a slight deviation with a 0,09 difference in 1998 and 0,22 in 1999. During the same period, Italy displays a similar tendency with a slight deviation in 1998 and 1999 being respectively of 60 and 53. On the basis of Big Mac Index figures and the observations outlined above, we can assert that transaction costs in the latter time frame are almost inexistent. As the Euro is introduced in 2002, the deviation between erate and PPP becomes less marked and rather small on the currency market USD/€. The curves for the monetary erate and the PPP now display a stable trend, lacking apparent drops and steep increases being no longer influenced by the market’s speculations and by variations of the country’s monetary policy. This trend behaviour is further indicated by the narrow range of values for the difference, which spans from 0,05 in in 2002 and 0,31 in 2009. This range however excludes a discontinuity that although small, results evident: the data value (2008, 1,59). In 2008 the difference became unexpectedly greater reaching 0,53, due to the financial crisis, and the strong speculative movements that came with it, especially in currency markets. As we can see from the erate USD/€ curve there is an increase which is not followed by the


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PPP curve, which stayed constant. Aside from the small discontinuity, the stable trend suggests that the Big Mac Index is forecasting the exchange rate much more accurately since the introduction of the Euro.

Given that PPP theory provides us with the exchange rate towards which any two currencies will move over time, we have also verified that our conclusions remain valid if we consider the lag variable, demanding a delayed adjustment of the market to parity. As we can see from Figures 2-5 under the entry 𝑒! − 𝑃𝑃𝑃!!!, the data confirms our hypothesis; the values for the difference are even smaller when the market is allowed to adjust in a wider time frame, and are generally smaller suggesting that the index has forecasted better after 2002.


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Chapter V: Conclusion The investigation succeeded in confirming that the establishment of a large currency market for Euro-using nations removes or significantly reduces all transaction costs associated to trade. Strictly based upon the results outlined in the analysis, which include explanations for the deviations by data and graphical approach (Figure 7), the actual exchange rate adjusted more closely to the PPP rate derived from the Big Mac Index after, rather than before the introduction of the Euro. The deviation is evidently smaller in the time frame 2002-2012, and more stable, highlighting the absence of speculations and volatilities associated to the many, relatively small currency markets. Surprisingly however the investigation found that the ability of the index to forecast exchange rates was maximised in the period between 1998 and 2001 as a result of the market’s reaction to the creation of a monetary union and an eventual introduction of a sole currency. This reaction was a product of the expectation determinant; investor’s expectation of the exchange rate adjusting to PPP, led them to demand a certain currency to the point that would have caused its devaluation until becoming equal to the ratio of the two prices, to PPP. Another relevant conclusion reached worthy of explanation concerns the deviation discontinuity between erate and PPP for the year 2008. We have concluded that it was a direct result of the financial crisis. The speculative movements of the Eurozone countries that have supported the Euro, beginning to render a greater integration of financial and monetary markets, this ultimately reinforced the Euro market, even further reducing transaction costs. The work’s hypothesis has been verified with empirical success; our claim that the transition to a larger market would have resulted in the cutback of transaction costs has been proved correct. The Big Mac Index has in fact, forecasted the US Dollar exchange rate more accurately when the Euro currency was introduced.


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i. Limitations to Investigation The main limitation behind this investigation was that only the Big Mac Index, an indicator comprising a single good, was used as a measure of Purchasing Power Parity. It would have been more accurate and complete in terms of results to use an index that included a variety of standardized goods to measure PPP. This would have allowed us to compare the results of a complete index, a broad “market basket”, to the results obtained in the investigation. Applications and empirical tests of PPP refer to a broad market basket of goods because it is intended to be representative of consumer spending patterns17. The Penn World Tables (PWT) for example, is an index that measures PPP for countries around the world including numerous individual items that encompass many different expenditure components of a country’s GDP. Alternatively the same study could be conducted on the Consumer Price Index (CPI) for different countries. This is left over for further study.

ii. Unresolved Questions and Further Analysis The main unresolved questions of this investigation include the following; not having explained the PPP, erate trend for France before the introduction of the Euro in 1992-2002 and the large deviation that characterized it and not having explained why Germany and Italy display similar trends before the introduction of the currency. Moreover another question would have been to explain why the three currencies prior to the Euro were undervalued, while the USD/Euro currency after 2002 came out to be over-valued, however the essay did not focus on analysing the currencies’ valuations. Everything else is left over for further study.

17 Pakko, Michael R., and Patricia S. Pollard. "Burgernomics: A Big Mac™ Guide to Purchasing Power Parity." Economic Research. Federal Reserve Bank of St. Louis, 1 Nov. 2003. Web. 19 July 2013. <http://research.stlouisfed.org/publications/review/03/11/pakko.pdf>.


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Bibliography "The Big Mac Index." The Economist. The Economist Newspaper, n.d. Web. 28 Sept. 2013. <http://www.economist.com/content/big-mac-index>. Wang, Jian. "Why Are Exchange Rates so Difficult to Predict?" EconomicLetters 3.6 (2008): 1-7. Federal Reserve Bank of Dallas. The Federal Reserve Bank of Dallas, June 2008. Web. 14 July 2013. <http://www.dallasfed.org/assets/documents/research/eclett/2008/el0806.pdf>. International Organization. The International Monetary Fund. Research Department. IMF Working Paper. By David Hauner, Jaewoo Lee, and Hajime Takizawa. International Monetary Fund (IMF), May 2010. Web. 17 July 2013. <http://www.imf.org/external/pubs/ft/wp/2011/wp11116.pdf>. Meese, Richard A. and Rogoff, Kenneth, 1983. "Empirical exchange rate models of the Seventies : Do they fit out of sample?", Journal of International Economics, Elsevier, vol. 14(1-2), pages 3-24, February. Ziogas, Constantine. "Purchasing Power Parity." Economics for the IB Diploma: Standard and Higher Level. Oxford: Oxford UP, 2008. Pg. 114 Print. Di Nino, Virginia, and Lionel Fontagnè. "Executive Summary." Preface. Study on the Impact of the Euro on Trade and Foreign Direct Investment. By Richard E. Baldwin. Brussels, Belgium: European Commission, Directorate-General for Economic and Financial Affairs, 2008. 5. Print. Suranovic, Steven M. “Chapter 6: Purchasing Power Parity.” International Trade:Theory and Policy. Irvington, NY: Flat World Knowledge, 2010. N. pag. Print. Pakko, Michael R., and Patricia S. Pollard. "Burgernomics: A Big Mac™ Guide to Purchasing Power Parity." Economic Research. Federal Reserve Bank of St. Louis, 1 Nov. 2003. Web. 19 July 2013. <http://research.stlouisfed.org/publications/review/03/11/pakko.pdf>. Dunn, Robert Jr. “Does the Big Mac Predict Exchange Rates?” Challenge, Vol. 50, No.3 (MAY-JUNE 2007), pp. 113-122. Published by M.E. Sharpe, Inc.

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