Understanding Economic Equilibrium

CHAPTER 30

Exchange Rates and Purchasing Power

When traveling abroad, despite the challenge of translating an unfamiliar currency into a currency you know, you would think most real prices to be about the same once you apply the exchange rate. It might be twenty units of one currency for one of another, but in general, you expect purchasing power parity, that is, goods selling at the same real cost despite the currency.

In 1986, The Economist magazine created the Big Mac Index as a tool for examining purchasing power parity. For example, if a Big Mac costs $2.50 in the United States and the exchange rate of the dollar in British pounds is 1.25, you’d expect a Big Mac at the McDonald’s on Old Kent Road in London to sell for two pounds. If the ...