Working Paper: NBER ID: w10074
Authors: David Parsley; Shangjin Wei
Abstract: 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.
Keywords: Real Exchange Rate; Purchasing Power Parity; Big Mac Index
JEL Codes: F31
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| deviations from the law of one price (LOOP) (F31) | real exchange rate (RER) movements (F31) |
| nontraded component of Big Mac prices (F31) | real exchange rate (RER) dynamics (F31) |
| speed of convergence for tradable inputs (F16) | speed of convergence for nontradable inputs (F16) |
| Big Mac RERs (F31) | price adjustments (L11) |
| reduced exchange rate volatility (F31) | deviations from LOOP in traded goods (F14) |
| lower transport costs (L91) | deviations from LOOP in traded goods (F14) |
| higher tariffs (F19) | deviations from LOOP in traded goods (F14) |