How to use economic theory to value currencies
Save time by listening to our audio articles as you multitaskThis thinking, known as “uncovered interest parity” , explains why the dollar has recently soared against the euro. On July 12th the greenback reached a one-for-one exchange rate with the euro for the first time since 2002. posits that changes in interest rates drive currency movements.
Yet there is more to currency valuation than monetary policy. Another theory, purchasing-power parity , says currencies and prices should adjust until a basket of goods and services costs the same everywhere.: the Big Mac index, which was updated on July 20th. Instead of a basket of goods and services, it uses differences in the price of the ubiquitous McDonald’s burger to judge whether currencies are over- or undervalued.
Our measure suggests the weak euro may be justified . The headline index, which assumes Big Macs should cost the same everywhere, predicts an exchange rate of 1.11 dollars per euro. But a secondary index, which adjusts for differences in-adjusted index takes into account differences in the prices of inputs, such as land and labour, that are hard or impossible to trade across borders, and therefore reflect local incomes. At dollar-euro parity, a Big Mac is 11% more expensive stateside.
For the euro, then, the two theories of currency valuation look aligned. Not so for the yen, which is more than 40% undervalued against the dollar on both Big Mac indices. The yen has become more undervalued since January, both because the dollar has surged and because inflation is much higher in America. A Big Mac in Japan, including taxes, costs ¥390, a price that has not changed since 2018. The American price, $5.15, has gone up by 11.5% in that time, and by 2.2% since January.
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