W.13_Lilly Wasitova_The Purchasing Power Parity


Problem Statement

 

To follow up on my blog # 12 regarding the Big Mac™ Index, it is time to look deeper into the theory of Purchasing Power Parity (PPP), since the PPP has been using US Dollar as the reference to determine the relative values of currencies, especially during the Global Economic Recession which has affected the United States the most. The Global Economic Recession started in 2007 and stabilized somehow in late 2008 to mid 2009.

 

To example to be used here is the price of Big Mac™ from [6] in seven selected different Counties/Area from the year 2007 to 2011, as below:

 


Table 1 : Big Mac™ Price [6] from 2007 to 2011

 

The Country/Area Selection is based on the highest and lowest price and the most stable countries during the recession, according to the IMF report [8]

 

Alternative Solutions

 

The Purchasing Power Parity Theory, which is one of the foundations of international economics, is stating that the price levels in any two countries should be identical after converting prices into a common currency [7]. So far all indexes are calculated by using the US Dollar as reference and if we take the prices from Table 1 and plot them in the below Graph, it is showing a non-linear lines for all Countries/Area and certain instability of increments over the period from 2007 – 2011.

 


Figure 1 : The Big Mac Price from 2007 to 2011

 

 

Taking the average Gold Price USD/Oz. from [4] from the year 2007 – 2011, with an almost linear increase as indicated by the linear trend line with R2 coefficient of 0.9828 as shown below, we can calculate the Index based on the Gold Price.


Figure 2 : The Gold Price [4] from 2007 to 2011 with trend-line

 

 

Selection Criteria

 

The selection criteria will be:

  • Using the data period from the year 2007 to 2011, using average values for all selected data.
  • Calculate the Index based on the Gold Price for all selected Countries/Area.
  • Compare the Indexes between the US Dollar based and the Gold based

 

 

Analysis and Comparison of Alternatives

 

The calculation of the Big Mac™ Price from US Dollar to Gold is given in the below Table:

 


Table 2 : The Big Mac™ Price in Gold [Oz. x 1000]

 

The R2 Coefficient for the Chinese Yuan [CNY] is the worse, since the graph is almost flat compared to others, whereas the US Dollar is on zero line as reference line for Over or Undervalue of the currencies.

 

 

Selection of the preferred alternatives

 

Plotting the Big Mac™ Index from [6] from year 2007 to 2011, as compiled in the below Table and shown in Figure 3, we can see that all Indexes showing an increasing trend from 2010, except for Hong Kong, which is showing a flat trend. This indicator was used as one of the argument that the global recession is already recovered in 2010.

 


Table 3 : The Big Mac™ Index [6] from Year 2007 to 2011

 


Figure 3 : The Big Mac™ Index [6] from Year 2007 to 2011

 

 

When we take the figures in Table 2., and calculate the Purchasing Power Parity Index based on Gold Price, we can see the result in the below Table and plotted in Figure 4:

 


Table 4 : Calculated PPP Index using Gold as Base from Year 2007 to 2011

 


Figure 4 : Calculated PPP Index using Gold as Base from Year 2007 to 2011

 

Comparing the trends in Figure 3 and Figure 4, we can see that

  1. In Figure 3 between Year 2008 and 2010, the recession only affecting overvalued Country/Area, in this case Euro Are and Switzerland, by having a declining Indexes, whereas all Undervalued Countries still having I slight increased Indexes.
  2. In Figure 4, all Countries/Area having a declining trend and all are Undervalued, except for Switzerland in 2007 with still positive Index Value. Between 2008 -2010, the declining Gradient is so showing a ‘nosedive’ trend especially for Switzerland, Euro Area and USA and after wards they are showing a slight slope only.

 

Performance Monitoring & Post Evaluation of Results

From the above calculation and above analysis, we can say that:

  1. The fact that the Global Economic Recession has an impact to all selected Countries here, but the impact of the recession mostly hit the US Dollar and as we can see from the declining trends also the Euro Area and Switzerland CHF.
  2. The Gold Price at the other hand is showing constant increase over the period of time and accumulatively over the period of 5 years, the increase is 65.5%
  3. The Big Mac™ price converted into Gold [Oz.x1000] is showing a reduced price over the time
  4. Taking the Big Mac Index and convert the values to Gold Price is saying that the US Dollar has a different behavior and cannot be seen as the stable reference for the Index.
  5. Comparing the PPP of Big Mac™ Index with the PPP of Gold [Oz.x1000] is seen that a contrary trends and behavior between the two Indexes, especially for the classification of under- and Overvalued.

 

References:

  1. Sullivan, William G., Wicks, Elin M. & Koelling, C. Patrick (1942), Engineering Economy 15th Edition, Singapore: Prentice Hall, Inc.
  2. Michael Bassard & Diane Riter (2010), The Memory Jogger 2nd Edition, Canada, GOAL/QPC
  3. XE, The World’s Favorite Currency Site http://www.xe.com/ucc/
  4. KITCO http://www.kitco.com/scripts/hist_charts/yearly_graphs.plx
  5. John K. Hollmann, PE CCE (2006), Total Cost Management Framework, A Process for Applying the Skills and Knowledge of Cost Engineering 1st Edition, USA, AACE International – The Association for the Advancement of Cost Engineering
  6. The Economist, http://www.economist.com/node/12991434?story_id=E1_TNJJTQPQ
  7. Michael R. Pakko and Patricia S. Pollard (2003), Burgernomics: A Big Mac™ Guide to Purchasing Power Parity, The Federal Reserve Bank of St. Louis
  8. International Monetary Fund (April 2009), World Economic Outlook – Crisis and Recovery, IMF Multimedia Services Division
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About Lilly Wasitova

Goal oriented professional who like to have fun
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One Response to W.13_Lilly Wasitova_The Purchasing Power Parity

  1. DrPDG says:

    WOW Bu Lilly!!! Looking mighty good!!! Keep this up and your paper will almost surely get picked up as a featured paper……

    But I need to see where you are taking it…… You’ve made an EXCELLENT case for using gold as the basis (see the convergence in Figure 4?) for cost indices, but to make your paper REALLY valuable, you need to somehow link this to cost estimating for projects……

    Explained another way, you have done an outstanding job on your analysis, but now you need to show how that analysis is going to help you solve or address your root cause problem.

    Keep up the great work, but you need to wrap this paper up cepat2!! Remember it is going to take you a day or so to run Viper and get it formatted in accordance with the AACE specifications!! And you would be wise to give me a couple of reviews before you are done…

    Busy weekend ahead, girl!!!

    Br,
    Dr. PDG, Jakarta

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