Case Study: Purchasing Power Parity Theory, Tortilla Prices and the Mexican Peso, January – February 2007
Background: According to the Purchasing Power Parity, exchange rate changes can be linked to changes in a country’s rate of inflation. As we noted in class, high rates of inflation are associated with weak currencies. The following is an example of this relationship.
March 5, 2007 (Bloomberg) -- An increase in the cost of tortillas, a staple of the Mexican diet since the Maya ruled 1,000 years ago, has triggered a slump in the peso.
Historians track the tortilla back about 1,000 years, when the Mayans controlled much of present-day southern Mexico from their base in the Yucatan peninsula. A flat bread made out of ground corn, quicklime and water, the tortilla is served at breakfast, lunch and dinner in many Mexican households. It's featured in some of the country's most famous dishes including tacos, enchiladas, quesadillas and flautas.
The tortilla accounts for almost half of the calories the average Mexican consumes each day. Lula Martin del Campo, head chef at HSBC Holdings Plc in Mexico City, said there's no food that has similar importance in the U.S. diet.
Tortilla prices jumped 5.9 percent in January, the most in eight years, after costs climbed for corn, the main ingredient. That increase fanned inflation and a bond market rout. It also resulted in falling demand for the Mexican peso on foreign exchange markets. In the past month, the peso has fallen 2.3 percent, making it the world's second-worst performer against the dollar among the 70 currencies tracked by Bloomberg.
``There's a big risk that tortilla price increases will lead to higher wage demands and fuel inflation,'' said Eduardo Perez, head bond trader at Mexico City-based brokerage Valores Mexicanos SA, the country's largest independent brokerage. ``Foreign investors don't like this environment and are selling the peso. This selling is directly linked to peso weakness.''
The currency's slide in the past month to 11.2165 pesos per dollar leaves it down 3.5 percent in 2007. The peso may fall further in the next several months as corn prices continue to rise. Corn has soared 16 percent in the past eight weeks and 121 percent since late 2005 as demand for the grain grows from ethanol producers. Higher corn prices are also driving up the cost of livestock feed, eggs, chicken and beef.
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