Despite the cost of living increasing 2.7 times since 1992 – the US$ exchange rate has only increased 1.6 times
Increase in the cost of living since 1992
A Stabroek Business article “Our purchasing power has fallen” (2 November 2007) prompted me to investigate the cost of living in Guyana. This article was inaccurate in that its tag line stated “A $1 in 1992 is worth .16 cents today”. Apart from the obvious error of including a decimal point (16 cents is .16 of a dollar) the logic used to come up with the 16 cents was flawed – you cannot take the current inflation rate and assume it has been in force for the last 15 years. The Bank of Guyana and more recently the Bureau of Statistics carry regular updates on their respective websites of increases in the cost of living in the form of the Georgetown Urban Consumer Price Index (CPI)).
I have collated this information and compiled the index values monthly since 1999 and annually prior to that date going as far back as 1970. Some care is needed as the inflation index was re-launched in January 1994 after moving into the ten thousands early in 1991. In terms of the new index, prices stood at 92.8 at the end of December 2002. At the most recent date of publication (July 2007) the CPI index stood at 248.6, so prices are 2.7 times greater now than they were in 1992: a dollar now would buy just 37 percent of what it could have bought 15 years ago.
To be honest this figure surprised me, as the rate of inflation compounded annually has thus averaged 7.0% over the 15 year period. It is quite frightening that it only took 15 years at this rate for the purchasing power of the Guyanese dollar to be eroded by almost two thirds.
(See art1) Looking at the chart of the year on year inflation in Guyana and the appreciation in the US$ against the Guyana dollar you would be tempted to think that the currency is overvalued: prices in Guyana have increased by far more than the currency has depreciated. However this analysis is fallacious at it completely ignores the level of prices in the US. The most widely used measure of inflation in the US is the consumer price index (CPI).
Comparison with US CPI
Over the period December 1992 to date the US CPI index has moved from 141.9 to 208.9 (source: http://inflationdata.com/inflation/Consumer_Price_Index/HistoricalCPI.aspx), an annually compounded rate of 2.7%. Thus the purchasing power of the US dollar has fallen by 32% over the last 15 years.
Since 1992 the Guyana dollar has moved from G$126 to the US$ to G$203.8 (using period end Bank of Guyana transaction figures) – a depreciation of 3.31% per annum annually. Thus prices in the US in Guyana dollar terms have increased over the period by some 6% per annum (2.7%+3.3%). This is less than the rate of Guyana CPI inflation over the period.
Because the rate of increase of Guyana prices has increased by 1% per annum more than the increase in US dollar prices in Guyana dollar terms, this suggests that prices for Guyana dollar goods and services are higher than the equivalent prices if we were to convert our Guyana dollars to US and purchase them in the US. Economists refer to this concept as the real exchange rate.
If goods and services in one country are more expensive than another then it makes economic sense to sell the currency where the good is more expensive, buy the currency where the good is less expensive and use the proceeds to purchase the good there. This process will tend to bring prices in line – selling the local currency will cause it to depreciate meaning that prices in the other currency will now be higher in local currency terms thus bringing equilibrium to the real exchange rate (RER). One famous example of a real exchange rate comparison is the “Big Mac index” which converts the prices of MacDonald’s Big Macs in countries throughout the world into US dollars. Those countries where the Big Mac is most expensive are said to be overvalued relative to other countries.
(See art2) Care is needed when interpreting real exchange rates: there are transaction costs involved in bringing goods from one country to another and there may be different fiscal policies in place between the countries distorting the relative value of goods and services. Nevertheless, real exchange rates are a useful indication of whether a currency is under or overvalued. Luis A.V. Cat