Why does a Big Mac cost less in China?

In July of this year, the Economist reported that a a Big Mac cost $7.61 in Iceland, $3.41 in the United States, and only $1.45 in China. The theory of Purchasing Power Parity says that arbitrage should push these prices together. The idea is that if goods are cheaper in China, exporters are more likely to ship them to the US, or tourists are more likely to travel to China to buy them. This will increase demand for Chinese yuan, drive up the exchange rate, and raise the price (in dollars) of the Chinese Big Mac. That this does not seem to happen is one of the biggest puzzles in economics.

Not so fast says colleague David Parsley and Shang-Jin Wei. In a new paper, find that price convergence is masked by the use of different price indexes in different countries (sushi in Japan, burgers in America). Once you look at individual goods, like the Big Mac, globalization really does push international prices closer together. These price diffrences will tend to disappear.

What this means is that the Economists "Big Mac Index" (explanation, video) can tell you which currencies are over-valued (Iceland), or undervalued (China) relative to the dollar. It seems as if economists are just finding out what currency traders knew all along.