0:25

Indeed, when I first started my career as an economist I started

Â in a private bank here in Switzerland, and I was a currency economist.

Â I realized how difficult it was to come with conclusions

Â whether a currency should go up or down based on economic fundamentals.

Â Because of this lack of measures, of yardsticks,

Â where you can say if you compare a currency to that level

Â then you can say a currency is under or overvalued.

Â So, by the end of this video,

Â you will be able to explain the only yard stick which we know, and

Â it's called purchasing power party, and we will see how you may define that.

Â And you see that there are two ways of defining purchasing power party,

Â the absolute way, the relative way.

Â And we will see how there are some,

Â a major problem when constructing an estimation were based on PPP.

Â And we will see also another funny example of a measure

Â relating to purchasing power parity, which is called the Big Mac parity.

Â 1:35

Okay, so defining purchasing power parity.

Â Basically, the idea is quite simple here.

Â The idea is that, if you have a currency and you're going to abroad,

Â so you're going to the United States, and you're based in India.

Â And you're going to the United States, and

Â say the cost of living is higher in the US than in India

Â then the idea of purchasing power parity is that you need a stronger currency,

Â a stronger rupee versus the US dollar.

Â To compensate for the fact that prices are higher in the US, and

Â if that condition is fulfilled then we say that PPP or purchasing parity holds.

Â 2:19

So in this example, we can say that PPP

Â is an estimation of a theoretical exchange rate.

Â It's actually not an observed exchange rate but it's very commonly used.

Â So let's see this with one example.

Â Let's take a representative basket of goods in the US which cost 100 US dollar,

Â and let's assumed that in Switzerland the same basket of goods cost 110 Swiss Franc.

Â So if PPP holds then the dollar should be

Â worth 1.1 Swiss Franc, and if that condition holds, then you would

Â be indifferent to buy the basket of good in the US or in Switzerland.

Â You would have the same purchasing power.

Â But if the exchange rate is not 1.1 Swiss Franc per US dollar but,

Â say, parity, 1 US dollar equals 1 Swiss Franc.

Â Then the Swiss Franc would be overvalued by 10% because

Â the basket is actually cheaper in the US than in Switzerland.

Â It would cost $100 in the US, and it would cost $110 in Switzerland.

Â 4:01

Basically, the idea is to compare the price of a Big Mac.

Â Okay, so here we don't have Big Mac, we just have simple hamburgers, but

Â you'll see why in a minute, but let's assume these are Big Macs.

Â Okay, this is the Big Mac which was bought in New York early this morning.

Â 4:17

It cost $4.79 to buy this, let's assume its a Big Mac again, okay.

Â Now, this is the same,

Â it was also bought in Beijing also early this morning, it cost 17 Yuan.

Â Okay, this was bought here just next door in Switzerland and it cost 6.50 Francs.

Â And last but not least, this was bought in Bombay, but

Â you see it somewhat different from the others, it's not exactly the same and for

Â one main reason actually in India, you don't find Big Macs made of beef,

Â but of other meat like lamb or chicken.

Â Okay, do what's the idea now here?

Â The idea is to compare the price of the Big Macs in the various country.

Â And derive from it the true value of the currency.

Â So we know that $4.79, and let's compare that to Switzerland, 6.50 Franc, okay.

Â So let's assume that we could buy this $479 with the current

Â value of the Swiss Franc, which is roughly 0.99 Swiss Franc per dollar.

Â So, which means that we paid this Big Mac in

Â the US something like 4.7 Swiss Franc.

Â 5:44

Okay, so there would be a very easy way to make a lot of money,

Â is actually to purchase a lot of these Big Macs in New York,

Â bring them back very quickly here to Switzerland, and sell them, say,

Â for 5.50 Francs, as opposed to 6.50 in the shop, in the McDonald's.

Â We could sell them cheaper, and still make 1 Franc gain per Big Mac we sell, okay?

Â So, to avoid this arbitrage that we buy these

Â hamburgers in the US and sell them here and make a profit, an easy profit.

Â Basically, these profits are cancelled if the currencies

Â are at their PPP rate measured by the comparison between

Â the price in the US and the price in Switzerland.

Â And we see basically, if we divide 6.50 by 4.79 we get 1.36 and

Â 1.36 Swiss Franc per dollar is the correct estimation of

Â where the Swiss Franc should be according to the Big Mac theory.

Â And now comparing this 136 versus the current exchange rate,

Â he would take 0.95, we see that the Swiss Franc is overvalued by more than 42%.

Â And on the same yardstick, using the same kind of

Â calculation, we can see that the Chinese Yuan or

Â MNB is undervalued vis a vis the dollar by also 42%, some 42%.

Â And the India rupee is actually even more undervalued,

Â by more than 60% versus the US dollar.

Â With this example, we just find out that the rupee is actually massively

Â undervalued vis a vis the dollar at more than 60%.

Â We saw the Big Mac parity as an example of absolute purchasing power parity,

Â and now we're going to have a look at the concept which is related

Â of relative purchasing power parity.

Â Here we're not comparing the price of one good, or a basket of goods, but

Â we're actually comparing the price evolution of a basket of goods, and

Â this is the inflation rate.

Â So let's take one example.

Â Let's assume that we're comparing the eurozone and Switzerland.

Â And let's assume that we have 11% inflation in the eurozone and

Â 1% inflation in Switzerland, and let us assume that we have,

Â we are starting in January 2000, which is when the Euro came into existence.

Â At that time, the currency of Euro for Swiss Francs was 160.

Â So you had to pay 160 Swiss Franc to purchase 1 unit of Euro.

Â 8:42

So according to the theory of PPP given that the prices,

Â the inflation rate is higher in the eurozone than in Switzerland.

Â Basically, you need an appreciating Swiss Franc to compensate for

Â these higher prices when you go into the Eurozone.

Â So, you see here the formula, and

Â you see that according to this inflation differential.

Â The Swiss Franc should be roughly 10% higher one

Â year after the euro comes into existence.

Â So the parity should be 145.58.

Â And you see the formula here.

Â How we get to this thing.

Â Basically, we multiply by the inflation differentials in between Switzerland and

Â the eurozone.

Â Now let's assume that a year after, in 2001,

Â we have still an inflation differential but lower.

Â We have that the eurozone inflation drops to 2%, and

Â the inflation in Switzerland remains at 1%.

Â Then we still need an appreciating Swiss Franc to compensate for the higher prices

Â in the eurozone, but only by roughly 1%, and you see here the formula again, but

Â with 2% inflation in the eurozone, and we get to 1.4515.

Â So this theory is that basically the currencies where inflation is high should

Â be depreciating versus the currencies of countries where inflation is low.

Â 10:23

So here is the formula.

Â And you see that the PPP rate, which again, and it's very important to know,

Â it's the only yardstick that we can think of

Â to measure whether a currency is over or undervalued.

Â So you see here how we can compute it.

Â We basically, take a currency exchange rate in the previous example it was 160.

Â And we multiply by P / P*.

Â P is the domestic inflation rate, and P* is the foreign, inflation rate.

Â But now there's a problem here.

Â And the problem is this with the E.

Â The first observation 160.

Â You see that in the previous example, we said okay, 160.

Â We start and then we have because of the inflation differential.

Â Roughly 10% of precision of the Swiss Francs and

Â we get to 1.4558.

Â But now we need to think of a major problem that we have.

Â We're estimating PPP and that relates to the E,

Â the first observation or what we called the anchoring point.

Â In the previous chart, we saw that it was 160.

Â I.e, the first quotation of the Euro versus the Swiss Franc when

Â the Euro came into existence in January 2000, 160, okay.

Â And then from this point, we anchor the inflation differentials, for instance,

Â after one year we saw it was one, 45, 58, because of the inflation differential.

Â Okay, the problem is, who says that 160 was the correct PPP in January 2000?

Â There's no theory which tells us that, and basically, I can show you a chart, and

Â this is the problem illustrated here in the following chart.

Â 12:14

We see the evolution, and

Â that's the red curve here of the Swiss Franc versus the Euro.

Â Now, let's assume that we choose January 08 as the anchoring point.

Â At that time, you see that the Swiss Franc was very weak versus the Euro.

Â The Euro was strong, it was 165, this is the strongest,

Â the Euro has been in its history versus the Swiss Franc.

Â So if we choose that as the base period,

Â the anchoring point you see we get this green dotted line here, and

Â what this green dotted line is telling us is that, today, according to the slide

Â the Euro should be worth 155 versus the Swiss Franc, okay.

Â That's extremely high for the Euro versus the Swiss Franc.

Â On the other hand, if we choose August 2011 as the base

Â period, the anchoring point, this e in the previous formula I showed you.

Â Then you see we get a completely different message because the black line

Â here ends up the last observation at parity.

Â So, the message here is to say if we choose that August 2011 as the anchoring

Â point then we would say that the Swiss Franc

Â is correctly valued versus the Euro today because the current

Â parity is 108, and the PPP is suggesting one.

Â Okay, but so you see here there is a major problem here,

Â it's the aprioriness of the anchoring point,

Â the first observation on which we hook the inflation differentials, okay.

Â So, the way to solve this problem

Â is through a technique which we call the regression.

Â This is a bit technical, we will put in a glossary the details for

Â those of you who are interested on how we can solve the problem

Â of the aprioriness of the first period.

Â Actually, a proxy way to solve this problem,

Â is to take some kind of average of all the exchange rate which are observed.

Â So here in this instance it would be from January 2000 to today December 2015,

Â it takes some kind of average, and that becomes your anchoring point.

Â 14:36

So but the academic way to solve this problem is through

Â what we call a regression technique, and

Â this is with constraint parameters, an elasticity of one.

Â Okay, I won't give you the full details

Â on the inflation differentials you can find the details in the glossary.

Â And once we do that, we get this blue line which we called here true PPP rate.

Â And here we can say that the Swiss Franc is overvalued.

Â We had already this message when we looked at the Big Mac Parity.

Â We have the confirmation here when we look at the broader set of goods,

Â not just the Big Mac.

Â And we see that it should be roughly worth 128 Swiss Franc per Euro.

Â So in conclusion,

Â we saw that with this video that the only way to measure the correct value,

Â the theoretical value of a currency is the so called PPP.

Â And the two ways to measure that, one is the absolute version of PPP,

Â Purchasing Power Parity, and we saw that with the example of the Big Mac.

Â And then there's the relative purchasing power parity which is used

Â when we take not just one good, the Big Mac, but

Â a basket of goods and we compare their price evolution in history.

Â 16:00

We also saw there's a major problem when measuring PPP, the relative PPP.

Â And that's the anchoring point and we find out the solution to this problem.

Â It's with this regression technique.

Â Again, it's not part of the course, it's in your recommended readings, but for

Â those of you who are interested, this is how we get to this true value of what

Â the Swiss Franc should be versus the Euro, and that value is 129.

Â Now, if we compare 129, the theoretical value of what the Swiss franc should be

Â versus the Euro to 108, which is the value of the Swiss Franc versus Euro today.

Â Then we have an overvaluation of 17% of the Swiss Franc versus the Euro.

Â 16:44

Now this overvaluation of the Swiss Franc vis a vis the dollar this time.

Â Remember, was really, really high, at 42%.

Â Again, when we look at the Big Mac parities,

Â we find that the Swiss Franc is the most overvalued currency in the world.

Â So the burger, are they still there?

Â Are they still around?

Â Yes, they are.

Â Yes, well, talking about the Swiss Franc 42% over

Â evaluation means that this burger here must be really good.

Â Because it's the most expensive one in the world.

Â So, let me see if that's correct.

Â [MUSIC]

Â Mm-hm quite tasty.

Â