A Prism into the PPP Puzzles: The Micro-Foundations of Big Mac Real Exchange Rates

The real exchange rate has been called the single most important price in an economy, yet its behaviour 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 the approach. First, unlike the CPI real exchange rate, we can measure the Big Mac real exchange rate in levels in an economically meaningful way. Second, unlike the CPI real exchange rate, for which the attribution to tradable and non-tradable components involves assumptions on the weights and the functional form, we know (almost) 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 real exchange rate in a setting free of several biases inherent in examinations of aggregate CPI based real exchange rates. These biases – the product-aggregation bias (Imbs, Mumtaz, Ravn, and Rey, 2002), the temporal aggregation bias (Taylor, 2001), and the bias generated by non-compatible consumption baskets across countries – are candidate explanations for the puzzlingly slow mean reversion alluded to by Rogoff (1996). Finally, we show that Engel's result that deviations from the law of one price are sole explanation for real exchange rate movements does not hold generally. We offer some evidence that departure from the Engel effect can be systematically linked to economic factors.