What’s the Big Mac Index and why it is cool? 😎
Main Idea
To Identify whether a country’s currency is overvalued or undervalued compared to other currencies.
Underlying Fact
The index is based on the economic concept of purchasing power parity (PPP), which suggests that in the long run, exchange rates should adjust so that the same basket of goods and services costs the same in different countries when expressed in a common currency.
Working
The Big Mac, being a globally recognized product sold by McDonald’s, is used as a representative basket of goods and services(like Labour, and transportation). By comparing the prices of Big Macs in different countries, The Economist aims to highlight differences in currency values. If a Big Mac is more expensive in one country than in another after converting the prices to a common currency(like USD), it suggests that the currency in the first country might be overvalued.
Example
Suppose the current exchange rate between Country A and Country B is such that 1 unit of currency in Country A is equivalent to 2 units of currency in Country B.
Now, let’s say the price of a Big Mac in Country A is 4 units of its currency, and in Country B, the same Big Mac is priced at 3 units of its currency.
To calculate the implied exchange rate based on the Big Mac prices, we can take the price in Country A and divide it by the price in Country B:
Implied Exchange Rate = Price in Country A / Price in Country B = 4 / 3
In this example, the implied exchange rate based on the Big Mac prices is 1.33 (4/3).
Now, let’s compare this implied exchange rate with the actual exchange rate:
Actual Exchange Rate = 1 unit of currency in Country A / 2 units of currency in Country B = 0.5
Comparing the implied exchange rate (1.33) with the actual exchange rate (0.5), we can see a difference. If the implied exchange rate based on the Big Mac prices is higher than the actual exchange rate, it suggests that the currency in Country A may be overvalued, and the currency in Country B may be undervalued.
