When somebody from the West travels to Southeast Asia, he cannot help but notice how very low the cost of living is relative to the West. How do we compare prices across countries? The Big Mac index gives us an approximation.
Purchasing power parity
Purchasing power parity is a measurement used to compare the purchasing power of the currencies of different countries. Purchasing Power is the amount of goods one can buy with one unit of currency. Here the goods are normally defined as a basket of selected items that households buy and form the consumer price index (CPI) as a measurement of the price of goods in a country. By dividing the CPI from one country by that from another, we obtain a ratio which is the purchasing power parity. The basket of goods is used because economic circumstances in different countries can differ.
According to the theory of purchasing power parity, the exchange rates should equal the rate that equalises the price of an identical basket of goods between countries. This is due to the Law of One Price, which says that without any trade barriers or transaction costs and with perfect competition, identical goods must have the same price (expressed in the same currency), regardless of location or market. This is equivalent to saying that no arbitrage opportunities exist. In this way purchasing power parity is sometimes used to predict exchange rates in the long term.
Big Mac Index
In 1986 The Economist magazine came up with a new way of measuring purchasing power parity. Instead of using a basket of goods, they chose to only look at the price of one good: McDonalds’s Big Mac. Core to the business models of fast food companies – and particularly McDonalds – is the consistency of their products in different stores over the entire world. Whether you buy one in Cologne or in Kuala Lumpur, a Big Mac is a Big Mac. The Big Mac is available in over 100 countries and this ubiquity combined with its similitude makes it a practical choice for the index.
By comparing the prices of the Big Mac in different countries, the idea was that one could approximate the purchasing power parity of different countries in a much simpler way. The price of a Big Mac is assumed to be an indicator of the price level of goods in a country and then one can compare the Big Mac exchange rate to the real exchange between two countries.
Overvalued or undervalued?
By the theory of Purchasing Power Parity and the Big Mac index, the exchange rate between two currencies should equal the exchange rate of the Big Mac prices. Normally, the dollar is taken as the currency against which another is compared and the Big Mac index then implies that it is either undervalued or overvalued to the dollar.
For sake of example, the price of a Big Mac in the United Kingdom in January 2023 was £3.79 and in the United States it was $5.36. The implied GBP/USD exchange rate is 3.79/5.36 = 0.71. However the real exchange rate was 0.81. This would mean that for 1 dollar on the currency market one got 0.81 pounds in return, while with that dollar you can only buy 0.71 pounds of goods (Big Mac) in the UK. This suggests, by the Big Mac Index, that the pound is undervalued by (0.81-0.71)/0.81 = 12.9% to the US dollar.
The Big Mac Index was originally intended as more of a joke but has now been adopted into serious textbooks. Let’s take a look at some of its imperfections.
The Big Mac is not everywhere. Though McDonalds is the largest fast food chain in the world and has over 69 million customers per day, it is not available in almost all of Africa (for which a KFC-index has been created instead) and parts of Asia. This makes it unfit to measure every currency. In some countries, fast food is relatively expensive compared with eating out in a restaurant and different price strategies work better in different countries. In short, cultural and economic differences make it difficult to have the Big Mac Index as a size fits all- measure for exchange rates. And the theoretical reason for why the exchange rates do not equal the Big Mac exchange rates is that property prices and services or labour costs are not necessarily the same in different countries.
Though it isn’t perfect, the Big Mac Index has found its place in modern economics. Or in the Economist’s words: “Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible.”