Buy a Big Mac in Norway and it will set you back US$6.81. Treat yourself to the very same culinary delight in China and your bank balance will be only US$2.45 lighter. This rather crude comparison embodies the argument that China, and indeed a whole host of emerging market currencies, are undervalued.
Big Mac Index: Lighthearted, tongue-in-cheek and half-hearted are just a few descriptions attributed to the Economist’s introduction of the Big Mac Index, in 1986. How serious they were with the index is questionable, but since it was devised, whole cottage industries have been developed by economists, traders, and teachers devoted to the concept… The idea behind Big Mac Index was to measure the percentage of under-or overvaluation between two currencies, in each nation, by comparing prices of a Big Mac hamburger…
The Big Mac hamburger is a standard consumer item sold in over 120 countries, and it is being used as the common comparison between nations. One often suggested method for predicting currency exchange rate movements is by comparing a sample of ‘basket of goods and services’ that should cost the same in both currencies. In the Big Mac Index, the ‘basket is a single Big Mac burger’, which enables a comparison between the currency of countries.
The method for determining the over-or undervaluation of currency pairs is based on ‘purchasing power parity’ (PPP). PPP is an economic theory and a technique used to determine the relative value of currencies, by estimating amount of adjustment needed on the currency exchange-rate between countries, such that; the exchange is equivalent to (or, on par with) each currency’s purchasing power. It asks how much money would be needed to purchase the ‘same goods and services’ in comparing countries, and uses this number to calculate an implicit exchange-rate.
The PPP exchange-rate calculation is controversial because of difficulties for finding ‘comparable baskets of goods’ to compare purchasing power across countries… that’s the rationale behind the Big Mac Index; it’s simple and easy to compare. Essentially, the exchange-rate is percentage of under-or overvaluation of a currency: A lower price means the first currency is undervalued compared to the second currency, while a higher price means the second currency is overvalued, in percent terms, against the first currency.
The basic concept is that prices will eventually equalize, over time. While this simple calculation may serve as a theoretical guide for determining under-or overvaluation of a currency, there are many limitations… Some organizations expanded the Big Mac Index concept, for example; UBS Wealth Management Research included the amount of time that an average worker, in a given country, must work to earn enough money to buy a Big Mac…
This working-time based Big Mac Index can give a more realistic view of purchasing power of average local workers, since it takes into account local variables, e.g., business costs, local wages… Also, there are several variants on the Big Mac theme; for example in 2004, it showed the ‘Tall Latte Index’, which replaced the Big Mac with Starbucks coffee. Another variation introduced by an Australian bank’s subsidiary, Commonwealth Securities, in 2007; where it adopted the idea behind the Big Mac Index to create an iPod Index. The bank’s theory was that since iPods are made in a single location (China), the value of iPods should be more consistent, globally. Still another variation on the theme is Bloomberg L.P. the Billy Index, where they convert local prices of the Ikea ‘Billy’ bookshelf into U.S. dollars and compares prices.
While economists widely cite the Big Mac Index as reasonable real-world measure of PPP, the burger theme has many limitations… For over twenty-years, the Economist remained firm on the view that the data they produced was light-hearted and should not be interpreted extensively; that it’s just a simpler way of viewing PPP theory… There is no doubt that popularity of the Big Mac Index stems from its simplicity, but whether it’s capable of predicting future trends– currencies, exchange-rates, competitiveness… is debatable. For many, however, the Big Mac Index is a useful economic theory that helps people to better understand currency fluctuations…
In the article What is the Big Mac Index? by Justin Kuepper writes: The Big Mac Index was created by The Economist based on the theory of purchasing power parity (PPP). Over the long-term, the PPP theory states that currency exchange rates should equal the price of a basket of goods and services in different countries. And what better basket of goods than McDonald’s Big Mac – or at least its equivalent – in various countries?
In theory, the price of a Big Mac reflects a number of local economic factors, ranging from the cost of the ingredients to the cost of local production and advertising. The resulting PPP metric is therefore considered by many economists to be a reasonable measurement of real world purchasing power. But there are exceptions to the rule: The Big Mac Index is calculated by dividing the price of a Big Mac in one country by price of a Big Mac in another country in their respective local currencies.
The resulting value is compared to official exchange rate, between the two currencies, to determine if either currency is undervalued or overvalued; according to the PPP theory. For example, suppose that a Big Mac in U.S. costs one U.S. dollar and one in eurozone costs two euros. The Big Mac Index valuation for EUR/USD would be 2.0, or two divided by one, which could be compared to the EUR/USD exchange rate. If the exchange rate was 1.5, you could predict that the euro was undervalued by 0.5 euros per U.S. dollar.
In the U. S. there may not be much need for the Big Mac Index, since there are already a number of reputable price indexes available, such as Consumer Price Index (CPI). But the index becomes useful in other countries where reliable indexes aren’t available, such as those that manipulate government statistics or those that don’t publish official data. For example, many economists believed that Argentina had been modifying its official consumer price data to understate its true rate of inflation between 2010 and 2012.
So, the Economist used its Big Mac Index to find that the average annual rate of burger inflation was 19% compared to country’s official 10% rate of inflation, in January 2011. Key takeaway points:
- The Big Mac Index was created by The Economist based on the theory of purchasing power parity (PPP).
- The Big Mac Index is calculated by dividing the price of a Big Mac in one country by the price of a Big Mac in another country, in their respective local currencies.
- The Big Mac Index can be used in many different ways, ranging from determining rates of inflation to comparing currency valuations.
In the article Real or Ridiculous–The Big Mac Index by Laurie Petersen writes: The Big Mac Index measures the relative price of a Big Mac in dozens of currencies. It’s based on the rule of purchasing power parity (PPP), which states that exchange rates should move to make the price of goods the same in each country. So how well does burgernomics work?
The Big Mac Index is useful for travelers, giving a good idea about which countries are expensive, and which are not, says economics professor Robert Barsky, University of Michigan. For example, if you’re traveling to Australia, plan on paying US$4 for the double beef patty sandwich. It’s less clear, however, that a pop-culture index is a good predictor of changes in the exchange rate over time, Barsky adds, because the Big Mac is in large measure, a measure of the non-tradable component of the Consumer Price Index (CPI). There is no strong reason that the prices of non-tradable should be equalized across countries.
While The Economist claims the index has been a pretty good predictor of movements in currency values, there’s no clear benchmark to compare to in order to evaluate how accurate it has been historically, adds Tara Sinclair, George Washington University. One thing we can see from the numbers is that it’s rare for a Big Mac to cost the same in dollars across countries, she says. According to a recent index, the Norwegian krone is one of more overvalued currencies against the dollar. Expect to pay around US$6.81 for a Big Mac in Oslo. The price for a Big Mac in China is US$2.45, or the Chinese yuan is undervalued. The price for a Big Mac in U.S. is about US$4.33…
The Big Mac Index is not perfect, at best; but for some it can be useful. For example, the Big Mac’s price is decided by the McDonald Corporation and it can greatly affect the Big Mac Index. Also, the Big Mac itself differs across the world in– size, ingredients, and availability. That being said, the index is meant to be light-hearted and a good example of purchasing power parity (PPP), and is used by many schools and universities to teach students about PPP. The goal of the Big Mac Index is to make exchange-rate theory a bit more digestible...
Burgernomics, as the Economist dubbed it, invented by one of their writers, Pam Woodall, and the Economist publishes it annually. The Index charts the price of a Big Mac burger for many countries all around the world, for example; the Big Mac is four times more expensive in Switzerland than in India. Comparing the price of a Big Mac in the U.S. with an Indian Maharaja Mac (this is made with chicken, since normal the Big Mac is not sold in mainly Hindu country) researchers found that the rupee is about 60% undervalued; compared to the U.S. Big Mac average of US$4.20. The India equivalent cost is about US$1.62. The currency that can purchase the next most number of Big Macs is the Ukrainian hryvnia, which is about 50% undervalued, according to the Index.
A Big Mac in Ukraine is US$2.11, that’s just one U.S. 1 cent cheaper than in Hong Kong, which was third runner-up for most undervalued currency. Norway’s currency the krone is the most overvalued currency by about 60%. A burger in Norway costs about US$6.81. Next, according to Big Mac Index, is Switzerland’s Swiss franc where a Big Mac burger costs about US$6.79… However, many economists argue that the Big Mac Index has serious flaws, and that the price of the Big Mac burger price should be adjusted for the relative purchasing power of the country’s local conditions, e.g., economy, worker wage…
But, according to Jonathan Perraton, University of Sheffield, says; with all of its flaws, the Big Mac Index raises some very important talking points, strategically; for example, are countries like China artificially keeping their currency at a relatively low-level, so they can price their goods artificially less expensive than most other countries and maintain a significant global competitiveness advantage... Also, Mr. Perraton goes on to say; the Big Mac Index is a good, rough guide for tracking fluctuations between currencies, plus– its fun, easy to explain and understand, and provides a creditable comparison of price, but it does have many limitation… In balance, however, for a back-of-the-envelope– ball park number– it does very well…
In the long run, the exchange rate between two countries should move towards the rate that equalizes the prices of an identical basket of goods and services in each country.