This is a follow-up to a much longer article in The Federalist.
The editors wisely suggested that I omit the description of Prof. Steve Hanke’s methodology. But they offered to link to this page. Bonus: here you can download my Excel workbook where I did the calculations.
Prof. Hanke’s Methodology
What folllows is from Prof. Hanke’s Cato website The Troubled Currencies Project.
The calculation of implied inflation rates in countries with troubled currencies requires only a working knowledge of purchasing power parity (PPP), some basic arithmetic, and the following data:
- the U.S. inflation rate, and
- Black-market exchange rates (local currency unit per U.S. dollar).
In this case the local currency is the Venezuelan bolivar.
Purchasing Power Parity
Purchasing power parity (PPP) says that the same good should have about the same price in different countries. The exchange rate should therefore be the ratio of the prices of that good in the two currencies. A good example is The Economist’s Big Mac Index of Purchasing Power Parity. The idea is that McDonald’s Big Mac is sold nearly everywhere. And the product itself is always the same. (There are reasons this is not a good product to use for PPP, but it’s entertaining.)
In January, 2018 a Big Mac in the U.S. cost $5.28. In Norway the price was 49.00 kroner. The implied exchange rate is 49 kroner/$5.28 = 9.28 kroner per U.S. dollar. The actual exchange rate was 7.85 kroner per dollar. The implication is that the kroner is overvalued with respect to the dollar. (If the exchange rate changed from 7.85 to 9.28, the kroner would have depreciated vis-à-vis the dollar. It takes more kroner to buy one U.S. dollar after the exchange rate change.)
The Economist has a nifty interactive tool. Among its many features are five different currencies available to use as the base currency (the denominator in the PPP calculation) and the ability to download the entire dataset as an Excel workbook.
Research has shown pretty conclusively that PPP generally forecasts the direction an exchange rate is likely to change in the future. Assuming it holds at any point in time is a stretch. But Prof. Hanke has made clever use of it, so here we are.
Using PPP to Estimate Inflation
When calculating the PPP exchange rate vis-à-vis Norway using the price of a Big Mac, we used equation (1). But The Economist does not have data for Venezuela. Even if Big Macs are sold there, they are undoubtedly covered by price controls. Economic models don’t work very well when market prices are suppressed.
We’re left with equation (3). The left side is one plus the foreign country’s inflation rate. The first term on the right is one plus the rate at which the exchange rate is appreciating or depreciating. The second is one plus the U.S. inflation rate.
Now we can make some progress. In March, 2018 the black market exchange rate depreciated by 42.3%. U.S. monthly inflation was 0.1%. Using equation (3) and a little arithmetic we find that monthly inflation in Venezuela was 42.5%. That translates to annual inflation of 6,888%. (Note that the Venezuelan inflation rate is very close to the rate of depreciation of the Bolivar. That’s because U.S. inflation is very small. In fact, a good approximation is to ignore U.S. inflation entirely.)
That loaf of bread that cost one Bolivar at the beginning of 2018 looks like it will cost nearly 69 Bolivars by the end of the year. In one month, the price will rise to 1.42 Bolivars. According to one report, a worker who got a year’s severance pay used it to buy a cup of coffee. At least he found a good that was actually available! Most likely it was black market coffee. (Sorry.)
Therefore, if PPP holds, and we know the percent change in the exchange rate (the black-market LCU per unit of USD, as explained above), we can estimate the percent change in the price level for the troubled currency country.