Introduction
The Big Mac Index is an informal measurement of PPP which was developed by The Economist in 1986. Purchasing Power Parity (PPP) is a method of comparing price levels in different countries and compares different currencies through a “basket of goods” approach. However, taking a basket of goods is quite an inaccurate way to represent the average prices of all goods and services in a country because each country has drastically varying baskets and a multitude of factors that can impact this very basket. Therefore, The Big Mac Index allows us to take a fairly standardized good — an example is a McDonald’s Big Mac, which is available in most countries — and use it to evaluate and compare currency exchange rates.
The theory of PPP states that in the long run, exchange rates should naturally adjust and move towards the rate that would make the price of the market basket, or in this case a Big Mac, equal in both countries. You can see all the latest data for the Big Mac Index in different countries here.
Calculations
The way these values are calculated are as follows:
- Divide the price of one Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency); eg. Indonesia = 34,000 IDR & United States = 5.66 USD ∴ the implied exchange rate or PPP = 34,000/5.66 = 6007.07
- Compare this value with the actual exchange rate; eg. 14,125 → The difference between this and the implied exchange rate from our calculation suggests the Indonesian rupiah is 57.5% undervalued.
“Undervalued” and “overvalued”
So what exactly do these terms “undervalued” or “overvalued” mean? An undervalued currency, for example, the Indonesian rupiah, means that the currency is worth less than its market value. This essentially indicates that the price of goods and services is lower in the target country, Indonesia, than in the base country, the United States. An overvalued currency, on the other hand, means that the currency is worth more than its market value and the exchange rate exceeds what the market is willing to pay; goods are relatively more expensive in that country. Overvalued exchange rates make imports cheaper than domestically produced goods and therefore tend to discourage domestic demand and encourage spending on imported goods. According to The Economist’s data for 2021, the countries with overvalued currencies when compared to the USD (not adjusted for GDP) are the Swedish krona, Norweigan krone, and Swiss franc.
Problems with the Big Mac Index
Although the Big Mac Index provides a simple and casual method to assess currencies and their relative values against each other and the global market, it is not without its flaws. Firstly, the Big Mac is not available in all countries, which limits the ability for global comparisons and has subsequently caused the rise of alternative indices, such as the KFC Index for African countries. Other factors which can limit the extent to which the Big Mac Index can serve as an accurate representation of currency values include demand, accompanied by the price elasticity of demand, of Big Macs. In certain countries, it is inevitable that the demand for a product like the Big Mac would be significantly lower than its demand in the United States. The index can also be impacted by the purchasing power of domestic consumers, how many hours they must work in order to afford a Big Mac, rates of taxation, domestic competition, factor input costs, and so on.
An interesting example to note is how the Russian ruble is calculated by the BMI as one of the most undervalued currencies as the Russian Big Mac is one of the cheapest. However, Moscow is one of the most expensive cities in the world! This could be due to the fact that although domestic food factor inputs are relatively cheap, restaurants suitable for business dinners with English-speaking staff are expensive.
Conclusion
All in all, the Big Mac Index is an insightful and easy-to-understand method for learning the basics of currency valuation and why it is important in global markets. However, it is worthwhile to note that this data must definitely be taken with a grain of salt, or perhaps a pinch of it, for your fries…?
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