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A crash course in everything Economics – Part 1

Stephen Kinsella’s new book, QuickWin ECONOMICS, answers 100 questions you might have on the subject. In this excerpt: Why don’t Big Macs cost the same in every country?

Image: Keith Srakocic/AP Photo

ECONOMICS, ECONOMICS EVERYWHERE – and not a person to explain them.

Economics lecturer Stephen Kinsella has decided to wade through the terminology to create a layman’s primer to help us understand the economic factors that are shaping our present – and our future. His new book, Quickwin ECONOMICS: Answers to your top 100 Economics Questions does exactly that.

TheJournal.ie brings you two of the questions and answers in the book today to get you started – and will bring you two more tomorrow.

Q: Why don’t Big Macs cost the same in every country?

A: Purchasing power parity exists when two countries’ exchange rates for currency equalise the difference in purchasing power between the two countries.

Think about two currencies, mediated by a flexible exchange rate, which means that, on any given day, the price of euros in terms of dollars changes with the demand for products denominated in the other currency. If we in Europe buy more goods and services from the US relative to their purchases of our goods and services, then the price of that foreign exchange – the exchange rate – will go up.

Now, the higher the price and costs levels are in Europe relative to the US, the greater our imports from the US. High EU prices and low US prices usually means a high price for foreign exchange. The relative change in the exchange rate is in fact proportional to the change in the price levels in the two trading countries. This is purchasing power parity at work, so that, all things being equal, the EU/US exchange rate is given by:

EU / US exchange rate = EU prices / US prices

What has this got to do with Big Macs? If you could buy a Big Mac in Europe for €2 and the exchange rate between the euro and the US dollar was €0.50 for every $1, then if purchasing power parity holds, you should be able to buy a Big Mac in the USA for $1. The Economist magazine routinely publishes the prices of Big Macs from all over the world to check for purchasing power parity. The Big Mac is sold in about 120 countries, so the Big Mac purchasing power parity indicator is the exchange rate that would mean hamburgers cost the same in America as abroad, if purchasing power parity held. Comparing actual exchange rates with those implied by the purchasing power parity exchange rate above can help us decide whether a currency is under-valued or over-valued.

It is precisely because currency exchange rates are subject to other pressures, not just purchasing power parity, that sometimes Big Macs do not cost the same in every country.

Q: If the government devalues the currency, will this help my business?

A: Governments sometimes have control over the exchange rates at which their currencies trade at relative to other countries. It may make sense to decide to devalue the currency in times of economic difficulty. A devaluation is just a downward movement in a country’s exchange rate relative to other countries’ exchange rates.

If there is a balance of payments deficit, then by devaluing the country makes its imports more expensive (since its currency buys less of other currencies), and its exports cheaper (since other currencies buy more of its goods and services for the same amount of their own currency), thus boosting demand at home and abroad for locally-produced goods.

If the economy is small and open, then the types of goods it imports and exports will be very important, because imports and exports will make up a large proportion of the total goods and services consumed in the economy. Any change in the exchange rate will affect the types of goods and services produced and consumed.

The domestic inflation rate is also very important – an increase in inflation over time could remove all of the gains that a devaluation brings by making locally-produced goods relatively more expensive.

Typically, a country’s balance of payments deficit tends to get worse immediately after a currency devaluation, since imports already contracted for and existing debt denominated in foreign currency become more expensive. However, once the prices of imports and exports adjust to the new currency exchange, the effects of the devaluation increase overseas demand for the country’s goods, causing the economy to move into a balance of payments surplus. The ‘j-curve’ shows the lagged effect of monetary policy changes on the real economy, especially with regard to export and import pricing.

So whether a devaluation will help your business depends on whether it is exporting (Yes), importing (No) or producing and selling locally (probably Yes).

Stephen Kinsella is a lecturer in economics at the University of Limerick. He holds a BA (Mod) from Trinity College, Dublin, in economics, an MEconSc and PhD from NUI Galway and an MA, MPhil and PhD from the New School for Social Research, New York, all in economics. He is interested in computable economics, experimental economics and Irish public policy.

QuickWin Economics is published by Oak Tree Press. It is also available as an iPhone app and an e-book.

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