Question

Browse the Internet and find the latest Big Mac Index data. What does the data show in terms of the value of the dollar relative to the euro, pound, and yen? Are these currencies over- or undervalued relative to the dollar?

Some observers believe that large U.S. government deficits will lead to higher inflation in the future. If this did happen, how could the PPP theory be used to forecast the impact of this higher inflation on the value of the dollar?

Answer 1

• Based on the latest (2018) Big Mac Index data released by the Economist, US has the highest PPP amongst Europe, UK and Japan. The euro, pound and yen are under-valued relative to the US dollar.

• Fiscal deficit occurs when government's expenditure exceeds its income. Inflation occurs when prices of goods and services increase with time. To understand the relation between inflation and exchange rates, we consider the 'Purchasing Power Parity theory of the Exchange Rate'.

• The formula is:

New exchange rate = Old exchange rate * (Inflation in country 1/ Inflation in country 2)

Example: USD/yen_(t+1) = USD/yen_(t) * [(Price level in USD_(t+1)/Price level in USD_(t)) / (Price level in yen_(t+1)/Price level in yen_(t))]

• This PPP theory gives us an estimate as to what the exchange rate will be a year from now if we know the inflation in both the countries. (Note: this theory has its limitations, which can be understood on further study)

• Empirical evidence shows inflation in developed economies is less sensitive to fiscal deficit.

• But it matters where is the majority of the government's spending is focussed on. If majority of it is focussed on buying oil/oil reserves, military spending, paying off debt, bailing out multinationals, etc., and only a small portion is spent on building infrastructure for school, healthcare, plants, etc. than inflation rises faster with fiscal deficit.

• Hence, fiscal deficit will definitely increase inflation in long term, if the government spend majority of its revenue on non-productive activities. And the equation stated above from the PPP theory, can be used to give us an estimate of US dollar value with respect to another currency, if we know the inflation in both the countries.