Economic globalisation brings that countries depend on Nominal Exchange Rate values for their economy development. In the last years this Nominal Exchange Rate in Colombia was revalued (Col$ per one dollar), but since the end of 2013 this Nominal Exchange rate has changed to be devalued. This information comes from Big Mac Index; this index is taken seriously in Colombia in order to take economic policies decisions. Although this Big Mac Index shows problems about labour cost adjustments, it makes its work. This note shows how this index is calculated and takes Colombia Big Mac Index as example.
Author: Humberto Bernal,
Economist,
e-mail: zhumber@gmail.com
Twitter: @Humberto_Bernal
Nominal vrs Real Exchange Rate
Nominal Exchange Rate is the price of foreign currency in terms of local currency; for instance, in Colombia case this Nominal Exchange Rate is Col$1,983 per dollar in January of 2014; the capital letter that economic theory takes to represent the Nominal Exchange Rate is E. The Real Exchange Rate is the price (cost) of foreign goods in terms of local goods; for instance, the MacBook Pro computer real price (cost) is 25 barrels of colombian crude oil; this real Exchange rate can be represented by the lower letter e; moreover, it can be calculates as:
e = Ep* / p
where E is the Nominal Exchange Rate; p* is the nominal price of foreign good; and p is the nominal price of local good.
The Exchange Rate under Purchasing Power Parity is related with one price for every good around the World, no matters the type of currency of each country; this exchange rate can be taken as the Nominal Exchange Rate that lets one price for a good around the World. Therefore, it means that a Big Mac hamburger in Colombia must have equal price as a Big Mac hamburger in States. In terms of above equation, we have a States Big Mac and Colombian Big Mac, but both hamburgers are the same; it means that their prices must have equal no matter the country where people stay. The equation related with this theory is:
1= Ep* / p
However, this equality is not held at all because of different labor costs in countries and Nominal Exchange Rate fluctuations. Therefore, the Exchange Rate under PPP calculated by the Economist researchers is that one that lets that this equality holds:
E'= p / p*
Taking information from the Economist magazine, the Big Mac price in Colombia was Col$8,600 in January of 2014, and the Big Mac price in States was US$4.6 in January of 2014, so the Exchange Rate under PPP is:
E' = (8,600 / 4.6) = Col$1,870 per dollar
The Big Mac Index
The Big Mac Index with above information gives information about the state of Nominal Exchange Rate compared with the Exchange Rate under PPP in percentage terms. The Big Mac Index formula is:
Big Mac Index =
[(Exchange Rate under PPP - Nominal Exchange Rate) / Nominal Exchange Rate]*100
[(Exchange Rate under PPP - Nominal Exchange Rate) / Nominal Exchange Rate]*100
If this index is positive means that the Nominal Exchange Rate is revalued (appreciated); if it is negative means that Nominal Exchange Rate is devalued (depreciated); if it is zero means the right Nominal Exchange Rate.
The Big Mac Index for Colombia has shown years of negative values and years of positive values, but on this short time it appears that no converge to zero. The Big Mac Index for Colombia was negative between 2004 and 2006, so the Nominal Exchange Rate was devalued; nevertheless, it went to revalue state in 2007 and 2008. By 2013 and beginning of 2014, this index gave information that Colombian Nominal Exchange Rate was devalued as figure 1 shows. As one can see, it appears that there is not evidence of convergence to zero, but it is too soon to assert this statement because time data is too short still, there are 10 years for Colombia.
Figure 1. Big Mac Index Colombia 2004-2014
(Annual data)
Source: The Economist web page.
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