The idea is that “in the long run exchange rates should move to equalise the price of an identical basket of goods between two countries”.
So, if we consider the Big Mac, it should cost your average Londoner as much as it costs a Canadian to buy a Big Mac in their respective countries’ currencies. But it doesn’t. In Canada, it costs $4 to buy a Big Mac whereas Europeans pay (the Euro equivalent of) $4.33. This means the Euro is overvalued. In contrast, my Chinese friends in Hong Kong are paying only (the yuan equivalent of) $1.90 for their burger.
And what meaning does all this have for you, gentle readers? Well consider this. When planning your next holiday, do you want to pay $1.90 for a basic burger, or join me on my 2012 holiday in paying $13 for the same meal?
Photo Credit: Roffe used under Creative Commons License.