Big Mac Index
Big Mac Index
The Big Mac Index is an informal way of measuring the purchasing power parity (PPP) between two currencies. It provides a view of the extent to which market exchange rates deviate from their true values.
The index is based on the theory of purchasing power parity (PPP). Under PPP, exchange rates between two countries should adjust to equalize the prices of an identical basket of goods and services across countries.
The purchasing power parity theory is based on the principle that a dollar should buy the same amount in all countries.
Why Big Mac as the basket of goods
In the case of the Big Mac index, the basket is the McDonald's Big Mac which is sold in about 120 countries. The Big Mac was chosen because it is available to a common specification in many countries around the world, with local McDonald's franchisees having significant responsibility for negotiating input prices. The Big Mac index enables a comparison between many countries' currencies.
The index is the exchange rate that would mean hamburgers cost the same in America as abroad.
History of the Big Mac index
The index was introduced by The Economist in September 1986.
The Economist introduced this method as a measure that "seeks to make exchange-rate theory a bit more digestible".
How the Big Mac index is calculated
The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency).
Big Mac price in GBP in London
Big Mac PPP (index) = ----------------------------------
Big Mac price in USD in USA*
* Average of New York, Atlanta, Chicago, San Francisco
For example, the cheapest burger is in China, at 11 yuan or that is $1.41, compared with an average American price of $3.22. This would be 3.42 Big Mac purchasing price parity meaning that the yuan at 11 market exchange rate would be 56% undervalued.
Relative to its Big Mac PPP the euro is 19% overvalued against the dollar. In contrast, the yen is 28% undervalued.
How the Big Mac index is used
After the value of the Big Mac index is calculated, it is then compared with the actual exchange rate. Comparing actual exchange rates with PPPs or with the Big Max index indicates whether a currency is under- or overvalued.
If the actual exchange is lower, then the first currency is under-valued (according to PPP theory) compared with the second.
If the actual exchange is higher, then the first currency is over-valued.
The Big Mac index: the most/least overvalued currency
The most overvalued currency as of early 2008 seems to be the Icelandic krona. The exchange rate that would make the price of an Icelandic Big Mac equal with an American Big Max is 158 kron to the dollar. The actual rate is 68.4. This makes the krona 131% overvalued.
The most undervalued currency is the Chinese yuan which trades at 56% below its PPP rate.
The Big Mac index values