Thursday, September 25, 2008
A lot of people ask me about this and try to understand the power of the rand compared to the dollar. So I’ll take a moment as this came up in conversation with the Beautiful Kate (mentioned earlier). Ok, so a lot of times I talk in terms of purchasing power. As my friend (biostatistician and Latin lover) Jose-Miguel says “just because a country’s currency is weak compared to the dollar doesn’t mean it’s weak within the country itself.” This is somewhat true. An exchange rate is a result of international/global supply and demand on the currency relative to others. So if I tell you that 7.8 rand is 1 dollar you might think everything in South Africa is 8 times the price in the US. That’s not true. And this is where purchasing power comes in. What can I purchase with 1 rand? What can I purchase with 1 dollar? How big is the basket of goodies (goods—products and services) in South Africa that I can purchase with 1 rand compared to the size of the basket of the same goodies in the US purchased with 1 dollar?
The problem arises with a large massive system of products and services that do not always follow each other. In other words, if we chose one good, say tic tacs, and compared how many a dollar can buy compared to how many a rand can buy you would get a different sense for the different purchasing powers than if we chose a sheet of printing paper to compare the purchasing power.
With most goods the purchasing power of the dollar is greater. It’s just much stronger in this global economy. Some people ask why? Shouldn’t it be possible for 1 dollar to equal 7.8 rand and yet within South Africa a Snickers bar to cost 20 cents (rand cents)? Yes, it is. But there is a theory called purchasing power parity. This is the theory that exchange rates between two currencies reach a stable point when the purchasing power is the same (we just spoke about purchasing power). So when a fixed basket of goods and services costs the same in both countries then the exchange rate is at a stable point. A better way of saying this is that in the long run, the exchange rate will change so that price of a certain good or service will be the same in two different countries.
Here is an example. Let’s say a really nice flat screen tv costs $400. The same tv (it’s the only one of its kind and people use it for basement home theatre centers; it does automatic translation of tv shows and dvd’s even if they don’t come with translation—don’t ask me how)---ahem, the same tv costs R100 in South Africa. Now let’s say the exchange rate is 2R/$1. Do you see that the R100 TV is $200 due to the exchange rate? So then American people will say “I’m not going to pay $400 when I can buy it on the internet from South Africa with free shipping and handling and get it for $200.” (Economists call this arbitrage, but never mind that) So Americans start buying the TV from South Africa. This drives up the value of the rand (remember when I explained awhile back about how buying a product from a company from another country drives up the value of that company’s country’s currency?—that takes explaining, as well). The value of the rand gets driven up so then the exchange rate changes. As the value of the rand increases and the exchange rate drops from 2R/$1 to 3R/$1 to R3.50/$1. The entire time, less and less Americans are buying the South African TV because the savings is less (when the exchange rate is R3/$1 the TV now costs the American $300 so she is only saving $100). Finally when the exchange rate slows and hits R4/$1 the price is equal and the extra demand for the rand caused by Americans buying South African TVs is gone because Americans are paying the same price at home. This is purchasing power parity. (NOTE***It doesn’t work if
1. there are transportation costs, transaction costs, tariffs, trade barriers (like shipping and handling or an import fee because it changes the price and that change to the price will affect the exchange rate since the consumer can absorb it)
2. the markets are closed. If South Africa doesn’t send its TVs to the US then Americans could never affect the exchange rate by buying them.
3. the goods are not tradable. This does not work with houses or purely local services)
So what economists like to do is to take a good or service that is tradable on the global market, and to use its price to compare purchasing power and to show purchasing power parity predictions. In other words, they will look at the price of an object like the Big Mac. If it’s $3 in the US and R6 in South Africa, they would guess an exchange rate of R2/$1 because then the R6 burger is actually $3 when you exchange money. They then look to see what the exchange rate is. When they see the actual exchange rate is really R6/$1 they say “No, wait! That South African burger costs only $1. It’s cheaper in South Africa. So the South African rand is undervalued because I predict Americans will buy the burger and cause the value of the rand to rise until the prices of the two burgers are equal.” So they will say that comparison of the price of the good between the two countries doesn’t match the exchange rate, so the Rand is UNDERVALUED and will rise in value through the exchange rate as the demand for South African things increases.
Hopefully that helps explain it. And below is the Big Mac Index again(obviously people don’t buy Big Macs from other countries, but they just use it as a PPP indicator). I think some people didn’t understand it the first time.
Many times when I speak about relative expense here I am referring to price using purchasing power or price as a percentage of the median income. This means if it’s a greater percentage of the median income in South Africa to buy A Toyota Prius than the percentage of the median income of a US person to buy the same Prius in the US, I would call that more expensive for the person with the median income (remember also that I said the median here is a better measure of central tendency of income than the mean (or average)). http://blogs.wsj.com/economics/2008/08/04/income-vs-gas-prices-an-update/