The Grey Chronicles

2009.April.11

BigMac Index: A Compendium



Big Mac

The Big Mac Index is based on the purchasing power parity theory. Purchasing power parity [PPP] is an economic technique used when attempting to determine the relative values of two currencies. It is useful because often the amount of goods a currency can purchase within two nations varies drastically; based on availability of goods, demand for the goods, and a number of other difficult to determine factors. PPP solves this problem by taking some international measure and determining the cost for that measure in each of the two currencies, then comparing that amount.

Galler (2008) writes:

“Using "The Big Mac Index" complex economic concepts are easily understood. This is "Creative Metrification" in its most elegant form. They have taken complex comparatives and demonstrated the measurements in terms just about everyone can understand and relate to.”

Initially the idea was somewhat of a joke by poking fun of Index publications. Invented in 1986 as a light-hearted guide to whether currencies are at their “correct” level, our “basket” is a McDonalds’ Big Mac, which is produced locally in almost 120 countries. The joke, labeled “burgernomics” by some, turned serious and as a result Big Mac Index is still going strong to this day. It was meant to be humorous, but there can also be a lot of truth in humor. The index as it turns out, is a great tool to measure PPP.

What can the Big Mac index do for you? The Index is used as a method of predicting exchange rate movements. Why? Because the rate between two currencies should naturally adjust so that the Big Mac cost the same in both the US Dollar and whatever currency we are comparing it to. The Big Mac was chosen because the Burger is basically the same wherever you go and more importantly, you can buy the same tasty Big Mac almost anywhere in the world.

The Economist magazine recently published their lighthearted look at world currencies with the 2009 Big Mac Index. World currencies are measured against the cost of a single Big Mac from McDonald’s fast food restaurants in each country. Ideally there would be a wide range of products used to measure the value of a currency, but that wouldn’t be nearly as interesting as using just a Big Mac.

According to the Economist’s (2009) study, the Euro is overvalued by 24% while the Chinese Yuan is undervalued by 48%. Generally the currencies of Asia are cheap, while those of Europe are expensive. A Big Mac that costs $3.54 in the United States will cost $4.38 in the Euro area, $3.30 in Britain, and a whopping $5.79 in Norway. That same $3.54 Big Mac will cost just $1.83 in China, $3.23 in Japan, $1.74 in Indonesia, $2.07 in the Philippines and as little as $1.52 in Malaysia.

Some economists believe that the price of a McDonald’s burger is a good indication of how much purchasing power a certain currency possesses. For instance, a McDonald’s burger in China might be more expensive than a McDonald’s burger in Canada. The Big Mac Index does have its shortcomings. A Big Mac’s price reflects more than just the cost of bread and meat and vegetables. It also reflects non-tradeable elements — such as rent and labor. For that reason, the Big Mac Index probably is best when comparing countries at roughly the same stage of development. In any case, there is no theoretical reason why non-tradeable goods and services should be equal in different countries. They look at currencies and how fairly valued they are compared to the currency of other countries. Cultural differences and countries at different stages of development are just two factors that make the Big Mac Index an unfair measure, but the annual look at exchange rates was never meant to be taken too seriously.

David Parsley and Shang-Jin Wei (2007) researching that despite increasing global economic integration, there continue to be large and persistent differences between countries in the prices of many otherwise identical products. They find:

“Big Mac prices have several advantages over CPIs. First, since the Big Mac is standardized across countries and its actual prices are observed, one can meaningfully study price differences of identical items across countries. . . The study also concludes that the use of aggregate price indices masks convergence in individual prices. This suggests that comparing national price indices is misleading because of cross-country differences in the price indices themselves”

This simply means that in BigMac economics: comparing the prices of burger ingredients confirms that globalization does make international prices converge.

iPod NanoThe CommSec iPod index, compiled by the Australian broker CommSec and launched in January 2007, is a modern day variant of the long-running Economist’#146;s Big Mac index. Both indexes are designed to test the theory that the same product should sell for broadly the same price if exchange rates are adjusted properly. The key difference between the iPod and Big Mac approaches is that Big Macs are made in a host of countries across the globe whereas iPods are predominately made in China. The CommSec iPod index is a way at looking at issues such as the impact of currency changes on consumer spending, globalization and retailer margins.

According to the most recent CommSec iPod index, Australia is the cheapest place in the world to buy an iPod (as of October 2008), a reflection on the recent fall of the Australian dollar when measured against the U.S. Dollar. The iPod index is not a direct measurement of currency exchange rates, but is designed to provide price comparisons of the same goods when purchased in different countries by foreign buyers. The price comparisons are based on the iPod 8GB nano in the value of U.S. Dollars.


Notes:

Galler, Larry (2008). Of Big Mac’s, Economics, and Us. Online: EzineArticles.com, 31 August 2008. back to text

James, Craig (2008). CommSec iPod index: Australia now leads the world. Online: CommSec, 03 November 2008. back to text

Parsley, David and Wei, Shang-Jin (2007). A Prism into the PPP Puzzles: The Micro-foundations of Big Mac Real Exchange Rates. London: Economic Journal, October 2007. back to text

The Economist (2009). CommSec iPod index: Australia now leads the world. Online: The Economist, 09 February 2009. Click here for graphic image. back to text

Disclaimer: The posts on this site does not necessarily represent any organization’s positions, strategies or opinions; and unless otherwise expressly stated, are licensed under a Creative Commons Attribution-Noncommercial-No Derivative Works 3.0 Philippines License.

Advertisements

2 Comments »

  1. I don’t think PPP or the big mac index is a very good indicator of currency strength. There are several things, such as wages or inputs, that are not accounted for in the calculation of PPP. Here is an interesting article about why PPP sometimes fails: http://www.mindreign.com/en/mindshare/Global-Economics/PPP-perfect-3f/sl35291137bp327cpp10pn1.html

    Comment by Jim Tressor — 2009.July.23 @ 14:49 | Reply

  2. Great post explaining the Big Mac index. I also wrote an article explaining some of the shortcomings of the index. Funnily enough it was about the same time.

    http://greenerdesktop.com/376/the-big-mac-index-and-global-economics

    Comment by Kimble — 2009.April.23 @ 00:59 | Reply


RSS feed for comments on this post. TrackBack URI

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Blog at WordPress.com.

%d bloggers like this: