Tuesday, October 19, 2010

The Rise and Rise of the Aussie Dollar

Now that the Aussie dollar has hit parity with the USD (if only briefly) currency issues are in the news. Over time, even with freely floating currencies it's possible for exchange rates to become skewed. One way to consider whether exchange rates are in line is through the concept of purchasing power parity (PPP).

A popular representation of PPP values is the Economist magazine’s tongue-in-cheek Big Mac Index, which compares the price of Big Macs around the world. According to PPP theory, the cost of Big Macs should be the same across countries once local currencies are converted to US dollars. A Big Mac in Switzerland ($6.78) will cost you a lot more than a Big Mac in China ($2.18) suggesting that the Swiss Franc is overvalued and the Yuan undervalued against the USD.

Right now the AUD is at 99.05 US cents. Now a Big Mac is $A4.35 meaning that it's worth $US4.31, which suggests that the Aussie is overvalued.

Big Macs are not really a good marker of PPP because they are generally considerably more expensive than local-food items in developing countries! There is also now an iPod Index, which does the same thing, but with a high technology, tradeable item rather than a basic food item This is significant because products that can be easily traded should, through the process of arbitrage, end up with the same price (allowing for exchange rates).

According to news reports Australia is one of the dearest places to buy an iPod Nano, suggesting also that the AUD is overvalued. In the real world, however, other factors play a big role, like the competitiveness of the US market and the costs of buying one in the US and sending it to Australia.

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