Using patty-power parity to think about exchange rates
The Big Mac index was invented by The Economist in 1986 as a light-hearted guide to whether exchange rates are at their ‘right’ level. It is based on the theory of purchasing power parity (PPP), the notion that in the long run, exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a hamburger) in two countries. Burgernomics was never intended as an accurate gauge of currency misalignment, just a tool to make exchange rate theory more digestible. Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of dozens of academic studies. For those who take their fast food more seriously, we also calculate a gourmet version of the index. The GDP adjusted index addresses the criticism that one would expect average hamburger prices to be cheaper in poor countries than in rich ones because labor costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today’s equilibrium exchange rate. The ratio of prices to GDP per person may be a better guide to the current real value of a currency.
Big Mac Index
How much does a Big Mac cost in one country compared to other countries.
What is the Big Mac Index?
The Big Mac Index is a tool developed by economists in the 1980s to examine whether the currencies of different countries offer similar levels of basic affordability. The Big Mac Index is based on the theory of purchasing power parity (PPP).
History of the Big Mac Index
The Big Mac Index was introduced by Pam Woodall in The Economist in September 1956 as an illustration of purchasing power, now published by the magazine annually. The traditional method of measuring PPP or exchange rates between two countries is that the exchange rate should be adjusted in such a way that a sample basket of goods and services should cost the same in both countries. In the Big Mac Index, the basket contains only a Big Mac Burger sold by McDonald’s worldwide (with some minor modifications). McDonald’s was chosen because it is available in almost all countries. To obtain the Big Mac PPP exchange rate between two countries, the price of a Big Mac calculated in the country’s currency is divided by the price of the Big Mac in another country. The value obtained will be the exchange rate. This value is then compared with the actual exchange rate. If the value obtained is more than the exchange rate, the first currency is overvalued. Conversely, if the value is less than the exchange rate, the first currency is undervalued compared to the second. The index also introduced a new word, “Burgeronomics”.
Variations
1. iPod Index: Like the Big Mac Index, an Australian bank introduced the iPod Index in 2007. But the theory ignores shipping and distribution costs, which can vary from one country to another, depending on the country’s distance from the manufacturing site. 2. Gold Mac Index: In this index, purchasing power parity is calculated based on how many hamburgers can be bought with one gram of gold in a given country. PPP is an economic theory that compares currencies across a market-based “basket of goods”. According to this theory, currencies are in equilibrium or at par when the exchange rate is the same in both countries. Every three years, a report is constructed and released by the World Bank comparing different currencies to the US dollar. The International Monetary Fund (IMF) and the Organization for Economic Cooperation and Development (OECD) use this report as an evidence to predict and recommend economic policies. Basket of goods refers to a fixed set of consumer products and services purchased by a consumer and valued on an annual basis. It is used to track inflation in a country. The basket of goods adjusts to changes in consumers’ buying habits. If a basket costs USD 100 in the US and GBP 200 in the UK, the purchasing power parity exchange rate is 1 to 2. Criticism of the Big Mac Index Despite being a reasonable measure in the real world, some economists criticize this index. The limitations of the index are as follows: 1. In many countries, eating at McDonald’s is relatively expensive compared to eating at a local restaurant. Therefore, the demand for a hamburger is relatively less. Therefore, it is not as globally acceptable. 2. The total price of a Big Mac burger will be dependent on local production, delivery cost, advertising costs, transportation costs and the status of the local market, which will be different between countries and not a reflection of total relative currency values. 3. McDonald’s high volume, low margin approach determines the profit range in many markets. In some places, a high margin approach maximizes profits. Therefore, the value set will not reflect the fair currency status. 4. the prices of a Big Mac also vary with the areas where it is sold. Therefore, a Big Mac sold in a major city may be more expensive than one sold in a small rural area.
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