The Big Mac Index |
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What does it mean?
• The Big Mac Index is an index published by The Economist as an informal way of measuring the purchasing power parity (PPP) between two currencies and provides a test of the extent to which market exchange rates result in goods costing the same in different countries.
• The Big Mac index was introduced in 'The Economist' in September 1986 by Pam Woodallas as a semi which is now humorous illustration of PPP, which is published by that paper annually. The index also gave rise to the word 'burgernomics'.
Understanding the Big Mac Index
• According to PPP theory, "Any change in the exchange rate between nations should be reflected in a change in the basket of goods."
• One of the key insights of the Big Mac Index is that a basket of goods in one country can rarely be precisely duplicated in another country.
• For example, an American basket of groceries and an Indian basket of groceries are likely to contain very different products. A Big Mac, though, is always the same, allowing for slight local differences in ingredients.
Measuring 'The Big Mac Index'
• 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). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued.
Example
For example, let's assume that a Big Mac in Europe costs €2 and a Big Mac in the United States costs $1. For EUR/USD, the Big Mac Index exchange rate would be 2:1 or 2.0.
However, on comparing it to the actual EUR/USD exchange rate, if the EUR/USD rate were 1.5, you could conclude that the Euro is undervalued by 0.5 Euros per US dollars or 25%.
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