LECTURE

SUPPLEMENT

6-1

The Terminology of Trade

In discussing the international flows of goods, services, and capital, we have made some important simplifications. We have used the terms net exports and trade balance interchangeably, although in practice these terms sometimes differ slightly in meaning. More importantly, we have also shown how the simple income identity requires that net exports equal net capital outflow, although in practice this is not precisely correct. These simplifications helped us highlight the important features of the analysis without bringing in too much detail. This supplement provides some additional background on concepts relating to the international flow of goods, services, and capital. The term trade balance is sometimes used to describe merchandise trade or the part of trade involving only goods, not services. When the term is used in this way, it is not equivalent to net exports. Net exports include trade both in goods and in services. For national income accounting this distinction is important because net foreign demand for domestic production includes purchases of services as well as goods. Another simplification we have made is to equate net exports with net capital outflow. Because residents of a country may earn interest on assets held abroad and/or earn wages from working abroad, national income may differ from GDP. In addition, because residents of a country may give gifts to and/or receive gifts from foreigners, their income again may differ from GDP. These net factor payments and net foreign transfer payments are important in measuring domestic saving and thus in measuring the difference between domestic saving and domestic investment. Since the difference between domestic saving and domestic investment equals net capital outflow, these payment flows have implications for the relationship between net exports and net capital outflow. To see how this changes the basic identity, first rewrite the GDP identity Y = C + I + G + NX as Y + Net Factor Payments + Net Foreign Transfers = C + I + G + NX + Net Factor Payments + Net Foreign Transfers, where income includes net factor payments from abroad and net transfer payments from abroad. Rearranging this equation gives Y + Net Factor Payments + Net Foreign Transfers C G I = NX + Net Factor Payments + Net Foreign Transfers. As in the text, domestic saving is given by income minus spending, so we can rewrite this equation as S I = NX + Net Factor Payments + Net Foreign Transfers or Net Capital Outflow = Current Account. The modified identity thus relates a broader measure of trade flowsknown as the current accountto net capital outflow. One final term sometimes used in place of net capital outflow is the capital account. When we experience positive net capital outflow, the capital account is said to be in deficit we are purchasing more foreign assets than foreigners are purchasing our assets (or equivalently, we are making more loans to foreigners than they are making to us). Thus, the condition that the current account equal net capital outflow is sometimes described by the condition that the current account and capital account must sum to zero.

139

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6-2

Saving and Investment in Open Economies

Our theory of the small open economy suggests that there should be no simple link between the level of saving and the level of investment. With perfect capital mobility, the level of investment depends primarily on the world interest rate, whereas the level of saving depends on the level of domestic output. Martin Feldstein and Charles Horioka made a somewhat surprising discovery in the face of this theory: There is a close correspondence between saving and investment in many countries.1 Figure 1 illustrates the Feldstein Horioka finding: It shows a scatterplot of domestic saving and domestic investment, each expressed as a percentage of gross domestic product, for 21 countries.2

Figure 1 The Saving Investment Correlation 0.37 0.36 0.35 0.34 0.33 0.32 0.31 0.3 0.29 0.28 0.27 0.26 0.25 0.24 0.23 0.22 0.21 0.2 0.19 0.18 0.18 0.2 0.22 0.24 0.26 0.28 Saving/GDP 0.3 0.32 0.34 0.36 0.38

1 2

M. Feldstein and C. Horioka, Domestic Saving and International Capital Flows, Economic Journal 90 (June 1980): 31429. The countries are those of the OECD except Iceland, Portugal, Turkey, and Yugoslavia. The data cover the period 19601974. Figure 1 is constructed from the data in Feldstein and Horioka, ibid., Table 1.

140

Investment/GDP

Source: M M. Feldstein C. H Horioka, Domestic Capital Flows, Economic Journal (June 1980): 319. S F ld i and dC i k D i Saving S i and d International I i lC i l Fl E E ii J J ll 90 319 (1980)

Chapter Supplements

141

Feldstein and Horiokas work has been updated and modified by many authors over the years. Although the correlation between saving and investment rates varies with particulars such as which countries are included and which time periods are considered, the basic finding remains the same: Countries that have high saving rates are also countries with high investment rates and countries with low saving rates are also countries with low investment rates. Should we conclude that capital is actually immobile? Not necessarily. Other evidence shows that interest rates on comparable assets are quite similar even though the assets are located in different industrial countries.3 And casual observation finds that financial markets seem to have become more global over time. Furthermore, since saving and investment are both endogenous variables, common influences on saving and investment could yield a positive correlation even if capital is completely mobile across national boundaries. Concern about common influences is the main reason why Feldstein and Horioka averaged saving and investment rates across long periods of time and studied the crosscountry relationship. This technique allowed them to separate the effect from short-run business cycle fluctuations that may induce a correlation between saving and investment within a country from year to year. But even over long periods of time, saving and investment continue to be endogenously determined, and common influences may still be important. One way that a correlation might occur is in response to sustained shifts in a countrys productivity or demographics that lead to an increase in its long-run investment rate and its long-run saving rate.4 For instance, a technological advance in one country may increase investment at the world interest rate and, because it also increases income, may lead to an increase in saving. Another possible reason for the correlation is that government policies may be oriented to running zero average trade deficits because certain constituencies favor balanced trade. Thus, saving and investment may be forced into equality over time through this policy of an average trade deficit equal to zero. Finally, as Supplement 5-3 emphasizes, long-run budget constraints apply equally to countries, just as they do to governments or households. Accordingly, a country cannot borrow (or lend) forevereventually the foreign debt will have to be repaid. This means that over long periods of time, a country will tend to have balanced trade and saving will tend to equal investment.

For details, see the survey by M. Obstfeld, International Capital Mobility in the 1990s, in P. B. Kenen, ed., Understanding Interdependence: The Macroeconomics of the Open Economy, Princeton: Princeton University Press, 1995. For details, see M. Obstfeld and K. Rogoff, Foundations of International Macroeconomics, Cambridge: MIT Press, 1996, 16164. See also L. Tesar, Savings, Investment and International Capital Flows, Journal of International Economics, 31 (1991), 5578.

LECTURE

SUPPLEMENT

6-3

The Open Economy in the Very Long Run

The small open economy model of Chapter 6 explains that the trade balance is determined in the long run by the levels of domestic saving and investment. For example, if domestic saving is less than domestic investment at the world interest rate, then net exports are negative and there is a trade deficit. The counterpart to this trade deficit is an increase in indebtedness to foreigners. The model of Chapter 6 evidently cannot describe the economy in the very long run because a country cannot run large trade deficits forever.1 At some point, the foreign debt must be repaid. Something is, therefore, missing from the Chapter 6 model if we wish to talk about the very long run. One approach to this problem is simply to recognize that aggregate saving and investment are indeed aggregates of the behavior of individuals, firms, and the government. At any given point in time, an individual may be in deficitthat is, she may be spending more than she is earning. But, as emphasized in Chapter 16 of the textbook, individuals make their consumption and spending decisions by looking over their entire lifetime. An individual who borrows now expects to repay laterit is not possible always to spend in excess of income. The same kind of intertemporal budget constraints apply to firms and to the government. As a result, a trade deficit today will be matched by a trade surplus at some point in the future. We can capture these kinds of ideas by a very simple amendment to our model. Suppose that consumption depends not just on current income but also on wealth: C = C(Y T, W). (As explained later in the textbook, we can derive such a consumption function from a realistic theory of consumption behavior.) Now, suppose that, in the long run, a country is saving less than it is investing and hence running a trade deficit. Foreigners are purchasing domestic assets, so domestic wealth is falling. As a consequence, consumption will fall and saving will increase over time. The increase in saving will tend to reduce the trade deficit. In the very long run, the economy will be in equilibrium where net exports equal zero. In this case, saving equals investment and so wealth is constant.

It may be possible for a country to have persistent small trade deficits, provided the foreign debtGDP ratio is not increasing over time.

142

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6-4

Benefits of a Trade Deficit

A common misconception on the part of the public is that trade deficits are bad for a country because they reflect either unfair trade by foreign countries or a lack of competitiveness at home. But since the trade deficit is ultimately determined by the difference between domestic saving and domestic investment, we need to understand how macroeconomic policies influence saving and investment before making judgments as the whether a trade deficit reflects good or bad policy. The following article from The Washington Post illustrates this point and also describes how the trade deficit may work as a safety valve for an economy that is growing more rapidly than its trading partners.

Our Friend, the Trade Deficit

It helps to keep the economy from overheating and inflation down. The U.S. trade deficit ballooned to a record level last year [1998], reaching $233 billion on a current-account basis. Although the deficit was smaller relative to the economy than the previous high reached in 1987, projections for this year show it widening to more than $300 billion and place the gap at an all-time high as a share of the economys output. The burgeoning deficit is likely to fuel protectionist sentiment already simmering in the steel industry and farm sector. And presidential hopeful Pat Buchanan has pledged to make the trade deficit a central issue in next years campaign. But the deficit is not caused by, and should not be attributed to, unfair practices of our trading partners. While ensuring fair play in international markets must always be an important aim of U.S. trade policies, the overall deficit says nothing at all about the success or failure of those policies. Instead, the expanding deficit is largely a symptom of faster economic growth at home compared with growth abroad, which has spurred a greater rise in imports to the United States than exports from the United States. This widening shortfall between receipts for exports and payments for imports requires Americans to borrow more from abroad. Whether this rise in foreign borrowing is good or bad depends on whether it helps finance an increase in domestic investment or merely substitutes for a decline in national saving. As in the 1980s, foreign borrowing has risen during recent years in line with an expanding trade deficit. But this time around, the rise in foreign borrowing has been associated with an investment boom that has outpaced a solid gain in national savingunlike the 1980s, when the rise in foreign borrowing largely offset a sharp drop in national saving. Accordingly, the mushrooming trade deficit along with the concomitant increase in foreign borrowing are helping support a rising rate of investment that already may be paying dividends through the recent step-up in U.S. productivity. Investment has surged by about three percentage points as a share of gross domestic product since the current expansion began in 1991, while the share of national saving has risen roughly 1.5 percentage points. The larger increase in investment compared with saving has been made possible by a jump in net foreign borrowing and the trade gap from roughly zero in 1991 to about 2.5 percent of gross domestic product in 1998. By comparison, the share of investment rose by just under one percentage point, and the share of national saving fell by two percentage points between 1982 (when the 1980s expansion started) and the peak tradedeficit year of 1987. This drop in saving was offset by a rise in net foreign borrowing and the trade deficit from about zero in 1982 to more than 3 percent of gross domestic product in 1987. The gain in national saving during the 1990s may seem surprising given recent attention-grabbing headlines about the personal saving rate falling below zero. But although private saving has dropped sharply, government saving has risen by more, pushing up national saving. The rise 143

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CHAPTER 6

The Open Economy

in government saving reflects an enormous swing in the federal budget from a deficit of $290 billion in fiscal year 1992 to a surplus of $69 billion last year. By contrast, during the early 1980s a decline in private saving was accompanied by an exploding federal budget deficit and a substantial drop in national saving. A common refrain of those days highlighted the evils of twin deficits, whereby foreign borrowing was seen as financing fiscal profligacy. But because todays widening deficit has supported a surge in investment financed by foreign borrowing, this solo deficit will pay off over time in productivity gains and a rising standard of living. Besides financing investments for the future, the trade deficit also provides economic benefits today. First, the deficit helps keep the economy from overheating as strong growth in business and consumer spending is met with imports. This safety valve has allowed the economic expansion to continue into its ninth year without hitting the capacity limits and bottlenecks so often seen at mature stages of an expansion. Second, the rising trade deficit had been accompanied by a decline in prices of imported goodsuntil recently, especially oil and related productskeeping a lid on inflation despite tight labor markets. The rate of unemployment has been at or below 4.5 percent for the past year, and below 5 percent for well over two years, with absolutely no sign of price pressure.

Finally, increased foreign competition associated with the widening trade gap has spurred recent gains in productivity as U.S. firms are forced to improve their efficiency. Indeed, the strongest gains in productivity during the past few years have been in the manufacturing sector, precisely where foreign competition has been keenest. Perhaps the best example is the significant gain in productivity over the past decade in U.S. auto manufacturing, which is universally viewed as a response to intense competition from abroad. And while such gains may sometimes result in lost jobs, the appropriate policy response is not to pull up the drawbridge and refuse to compete but to provide adjustment and training assistance to workers. Over the next year, international trade critics likely will point to record-breaking U.S. deficits as a symptom of failed trade policies and unfair competition from abroad. But the trade deficit tells us nothing about whether competition is fair or unfair in any particular marketonly economic analysis on a case-by-case basis can uncover violations of trade rules. The deficit, however, does reflect a shortfall of national saving relative to domestic investment. And on this score, the deficits recent rise has been associated with a surge in investment that should enhance future economic performance.

Source: Robert G. Murphy, Our Friend, the Trade Deficit, The Washington Post, Friday, May 21, 1999; A31.

ADDITIONAL

CASE

STUDY

6-5

How Businesses Respond to the Exchange Rate

Companies engaged in international trade monitor the exchange rate closely. The following article from the New York Times shows how some industries responded in early 1993 to a fall in the real exchange rate. According to the article, net exports do respond to changes in the exchange rate, but the response may take some time.

No Quick Gain from Stronger Yen

The Clinton Administration is proclaiming the dollars latest plunge against the yen as a windfall for Americaone that should finally shrink the nations painful trade deficit with Japan. The stronger yen is the best single thing that could have happened to the trade deficit, a senior Administration official said last week. But improvement is not likely to come quickly, even though a stronger yen pushes up the price of Japanese goods sold in the United States while enabling American products to be sold for less in Japan. Indeed, the yen might have to stay strong for two years or more, many experts say, to have much impact on American-Japanese trade. The reason is that American and Japanese companies are resisting any adjustment in prices to reflect the changing values of their currencies. Cooper Industries, for example, exports spark plugs and crankshafts to Japan, but as with many American companies, Cooper says it will not cut the yen prices of its products. . . . But the stronger yen and weaker dollar certainly give American companies a pricing advantage in their competition with the Japanese, if the companies want to use it. In two months, the dollar has fallen 11 percent against the yen, to 110 yen to the dollar, compared with 124 in February. At 110, the level is the lowest since World War II. That means that an American-made spark plug sold in Japan for 124 yen now brings the manufacturer $1.11, rather than
Source: New York Times, April 26, 1993, D1.

$1 collected in February. That leaves room to cut the yen price, which could increase sales in Japan. The Japanese, conversely, must raise dollar prices in the United States to collect the same number of yen once the dollars are exchanged for the Japanese currency. A few companies, including Honda and Nissan, announced price increases this month . . . . The Clinton Administration is counting on the yens strength to shrink the trade deficit . . . . Administration officials even cite a trade theory that says that for every 1 percent increase in the value of the yen, the trade deficit with Japan will eventually shrink by $5 billion. The Boeing Companys transactions with Japan tend to support this theory. Boeing prices the planes it sells to Japan in dollars, not yen. So the fall in the value of the dollar means that the Japanese can spend less in yen to buy the dollars to buy the planes. We sell planes under long-term negotiated contracts, and we dont expect any impact on prices from the latest currency changes, said Paul Binder, a Boeing spokesman. Boeing, the nations single biggest importer, sold the Japanese $2.5 billion in commercial airliners last year, or 5 percent of the total American exports to Japan in 1992. The shipment to Japan will be similarly large this yearand less costly to the Japanese in yen, which could encourage them to buy more planes.

145

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CASE

STUDY

6-6

Tourism and the Exchange Rate

Expenditures on international tourism are likely to be sensitive to changes in exchange rates because a significant amount of tourism probably represents discretionary purchases that are sensitive to relative prices. Vacations taken abroad by Americans contribute to U.S. imports, while expenditures by foreigners on visits to the United States add to U.S. exports. Table 1 presents the percentage change each year in real tourism exports and imports between 1973 and 2010, along with a measure of the real exchange rate. As the table shows, the sharp appreciation of the dollar during the early 1980s was accompanied by a decline in tourism exports and a rise in tourism importslikely reflecting a decline in foreign visits to the United States and a rise in Americans venturing abroad. During the mid to late 1980s, as the dollar reversed course, exports rose and imports fell (or generally grew more slowly). In the late 1990s, as the dollar again gained value, exports declined and imports grew more quickly. During the early 2000s, both tourism exports and tourism imports fell sharply as a result of the pullback in travel following the September 11 attacks. A rebound in both exports and imports occurred in 2004, as the initial shock of the attacks began to recede. By 2005, the expected pattern appeared to be reasserting itself, as a weakening dollar was associated with increased exports and more slowly growing imports.
Table 1 Year
1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

Real Tourism Exports (% change)

18.5 7.1 4.1 13.6 1.3 8.9 11.9 10.8 10.2 9.3 9.8 Break in series 1.8 13.9 12.1 20.6 18.6 18.1 2.8 8.8 3.1 0.5 6.9 7.6 4.1 3.5 0.7 4.4 13.5 6.8 8.0 11.0 4.7 1.3 8.5 9.3 9.5 5.5

Real Tourism Imports (% change)

1.2 8.3 2.4 7.0 2.3 5.5 0.9 0.8 8.6 13.5 16.9 Break in series 11.6 6.1 16.8 2.5 3.9 8.8 10.9 3.1 5.9 6.0 2.5 4.6 8.4 12.0 2.5 10.3 7.4 8.5 6.2 9.9 0.8 0.4 2.6 1.7 6.9 1.1

Real Exchange Rate (Index, March 1973 = 100)

99.0 95.6 94.5 94.5 92.9 87.3 88.4 89.8 96.6 106.1 110.6 117.9 122.7 107.4 98.7 92.1 93.8 91.2 89.7 87.8 89.1 89.0 86.5 88.5 93.2 101.2 100.3 104.2 110.2 110.3 103.6 99.0 97.3 96.2 91.6 87.8 91.4 87.1

Source: U.S. Department of Commerce, Bureau of Economic Analysis and Federal Reserve Board. Note: Real tourism exports and imports are constructed by summing travel and passenger fare categories measured in 2005 chained dollars available from the National Income and Product Accounts (http://www.bea.gov). The real exchange rate is a weighted average of the foreign exchange values of the U.S. dollar against the currencies of a large group of major U.S. trading partners. The index weights, which change over time, are derived from U.S. export shares and from U.S. and foreign import shares. For details on the construction of the weights, see the Winter 2005 Federal Reserve Bulletin.

146

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STUDY

EXTENSION

6-7

The Exchange Rate and the Inflation Rate

The relationship between the nominal exchange rate and the inflation rate is particularly evident for countries experiencing hyperinflation. If the price level in one country is increasing rapidly, then movements in foreign prices and in the real exchange rate will be relatively insignificant. We therefore expect to see depreciation of the domestic currency at a rate approximately equal to the inflation rate. Figures 1 and 2 illustrate this for the Israeli and Mexican hyperinflations of the 1980s.1
Figure 1

Inflation and Exchange Rate Change, Israel, 19791990

180 140 100 60 Percent 20 20 60 100 140 180 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 Change in log CPI Change in log exchange rate

Figure 2 100 75 50

Inflation and Exchange Rate Change, Mexico, 19841994

Change in log CPI

Change in log exchange rate 25 Percent 0 25 50 75 100 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994
Source (Figures 1 and 2): International Monetary Fund, International Financial Statistics.
1

Figures 1 and 2 present changes in the logarithms of the two variables. The change in the logarithm is a measure of the growth rate of a variable. The close negative relationship between the inflation rate and the change in the exchange rate thus illustrates that price level increases were indeed matched by currency depreciation. See Supplement 7-5, Growth Rates, Logarithms, and Elasticities, for more information on growth rates and logarithms.

147

ADVANCED

TOPIC

6-8

Covered Interest Parity

Suppose that a U.S. company wishes to purchase goods from a U.K. producer. The U.S. firm agrees to take delivery of the goods three months hence and to pay an agreed-upon price in U.K. pounds at that time. The U.S. company, however, might be concerned about exactly what was going to happen to the dollarpound exchange rate over the next three months.1 It can avoid this uncertainty by buying U.K. pounds at the forward rate. International financial institutions not only buy and sell currencies at the current (spot) rate, they are also willing to write an agreement to exchange currencies at a future date and at a prespecified rate. Thus, if the U.S. company needs 10,000 pounds in three months time, it knows now that it will have to pay 10,000/f dollars at that time, where f is the appropriate forward rate.2 There is an important relationship between the spot rate (e) and the forward rate ( f) that is guaranteed by arbitrage. An investor could take a dollar, invest it at the U.S. interest rate (say in three-month Treasury bills), and earn (1 + i) dollars at the end of three months. Alternatively, she could convert her dollars into pounds (obtaining e pounds), invest those pounds at the U.K. interest rate [obtaining e(1 + i*) pounds at the end of three months], and then exchange those pounds for dollars at a previously agreed-upon forward rate. These transactions would earn the investor (e/f)(1 + i*). Both transactions must yield the same return, for otherwise, she could make arbitrarily large riskless profits by borrowing in one country and investing in the other. Thus, we have 1 + i = (e/f )(1 + i*). If we define the forward premium to be (f e)/e, then we have a good approximation3: Premium i* i. The premium will be positive (i.e., the forward rate will be above the spot rate) if the U.K. interest rate exceeds the U.S. interest rate. The premium will be negative if the opposite is true. The forward rate should be a good predictor of the future spot rate. To see this, note that if investors expect the spot rate in the future to be lower than the forward rate, they would buy pounds forward. For each pound, they agree to pay 1/f dollars. They expect each pound to be worth 1/ee dollars, where ee is the expected future spot rate, so they expect to make a profit. Similarly, if investors expect the spot rate in the future to be higher than the forward rate, they will sell the foreign currency forward. Thus, we can look to the forward rate for information about the markets expectations of exchange rate movements.4 Remember also that we expect to see appreciation of the nominal exchange rate in the long run if domestic inflation is lower than overseas inflation. Thus, one reason why we might see a positive forward premium is that domestic inflation is relatively low, so investors expect the dollar to be more valuable in the future.

1 2 3

This is a particular concern since exchange rates can be quite volatile in the short run. See Chapter 13 of the textbook and Supplement 13-11, Exchange Rate Volatility. Note that we are, of course, defining the forward rate (f) in an analogous manner to the spot rate (e)it is the number of units of foreign currency per dollar. To see this, let the premium be p. Then, f/e = 1 + p, so the arbitrage condition is (1 + p)(1 + i) = (1 + i*). Since p and i are small numbers, their product is very small and can be ignored; multiplying out thus gives the result in the text. Note that this is exactly the same as the reasoning used to derive the Fisher equation (Supplement 5-6, Deriving the Fisher Equation). This underlies uncovered interest parity, which is discussed in more detail in Supplement 13-7, Uncovered Interest Parity.

148

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CASE

STUDY

6-9

Purchasing-Power Parity and Real Exchange Rates

If the principle of purchasing-power parity provided an accurate theory of real exchange rate determination, then we would expect real exchange rates to be relatively stable. Major shortrun fluctuations in the real exchange rate would not occur because of arbitrage in goods markets. Such stability is, quite simply, not observed in the data. As an example, Figure 1 shows the real exchange rates for Canada, the United Kingdom, and Japan. Economists, therefore, look to behavior in financial markets rather than goods markets for explanations of short-run fluctuations in exchange rates.

Figure 1
160 140 120 100 80 60 40

Real Exchange Rates, 19732009 (Foreign Currency per U.S. Dollar, Index, 1973 = 100)

Canadian Dollar

UK Pound

Yen

1973 1976

1979

1982

1985

1988

1991

1994

1997

2000

2003

2006

2009

Source: Federal Reserve Board and U.S. Department of Labor, Bureau of Labor Statistics. Note: Real exchange rate is computed as nominal exchange rate multiplied by ratio of U.S. consumer price index to foreign consumer price index.

149

CASE

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EXTENSION

6-10 More on the Big Mac and PPP

The following graphs use the series of Big Mac prices and exchange rates collected by The Economist to illustrate the failure of PPP.1 For each of the four countries (Canada, Germany, Hong Kong, and South Korea), the graph shows the actual exchange rate (foreign currency per U.S. dollar) and the exchange rate implied by PPP. The latter is simply the ratio of the price of a Big Mac in each country to the price of a Big Mac in the United States, both prices measured in local currency terms. If PPP held, the actual exchange rate and the PPP implied exchange rate would be the same. If the actual exchange rate is above the PPP implied exchange rate, then the dollar is said to be undervalued. If the actual exchange rate is below the PPP implied exchange rate, then the dollar is said to be overvalued. The dollar was undervalued relative to the deutsche mark throughout the sample period. Thus, it cost more to buy a Big Mac in Hamburg, Germany, than in Hamburg, Connecticut. In contrast, the dollar was overvalued relative to the Hong Kong dollar throughout the sample period. Thus, it cost less to buy a Big Mac in Hong Kong than in the United States. (Hong Kong fixes the value of its currency relative to the U.S. dollar, which explains the lack of variability in the exchange rate line in the graph.) For most of the sample period, it would have been cheaper to buy a Big Mac in Windsor, Ontario, than in Detroit, Michigan, with the exception of 1992, when the reverse was true. From 1989 through 1997, a U.S. traveler to Seoul, Korea, would be advised to squelch the urge to have a Big Mac attack until he were back on American soil. While the Asian financial crisis resulted in a sharp appreciation of the dollar relative to the won, the relative price of a Big Mac in Seoul did not rise nearly as much. As a result, it is now cheaper to consume a Big Mac in Seoul than in San Francisco.
Canada

1.6

1.4 e 1.2

C$/US$

1 PPP .8

1988

1989

1990

1991

1992 e

1993

1994 PPP

1995

1996

1997

1998

A number of studies use the Big Mac data to analyze PPP. See, for example, R. Cumby, Forecasting Exchange Rates and Relative Prices with the Hamburger Standard: Is What You Want What You Get With McParity? National Bureau of Economic Research Working Paper no. 5675 (July 1996); M. Pakko and P. Pollard, For Here or To Go? Purchasing Power Parity and the Big Mac, Federal Reserve Bank of St. Louis Review (January/February 1996): 321; L. Long, Burgernomics: The Economics of the Big Mac Standard, Journal of International Money and Finance (December 1997): 86578; R. Click, Contrarian MacParity, Economics Letters (November 1996): 20912.

150

Chapter Supplements

151

3.0

Germany

2.5 DM/US$ PPP 2.0 e 1.5

1.0

1988

1989

1990

1991

1992 e

1993

1994 PPP

1995

1996

1997

1998

9 8 7 HK$/US$ 6 5 4 3 2 PPP e

Hong Kong

1988

1989

1990

1991

1992 e

1993

1994 PPP

1995

1996

1997

1998

1500

South Korea

1200 won/US$

PPP

900

e 600

1989

1990

1991

1992

1993 e

1994 PPP

1995

1996

1997

1998