A Beginner’s Guide to the Big Mac Index
What is the Big Mac Index?
The Big Mac index was first used by The Economist
in 1986 as an informal guide to purchasing power parity (PPP)
. The basket of goods in this case is a Big Mac. It was chosen because McDonald’s is almost present in every country in the world and the ingredients of making a Big Mac stay pretty much the same.
According to PPP theory, a Big Mac should cost the same in every country. By comparing the Big Mac PPP and the market exchange rate, economists can estimate whether a currency is overvalued or undervalued.
We can compare the US Dollar and the Chinese yuan using the figures produced by the Economist in January 2014.
- The price of a Big Mac was $4.62 in the US
- The price of a Big Mac was ¥16.60 in China
- This means that PPP rate for Big Mac was $1 : ¥3.59 ($16.60/ ¥4.62 = 3.59)
- The market exchange rate at the time was $1 : ¥6.05
- If the exchange rate was in equilibrium, these two figures should be the same. However, they were not, which means that in January 2014, the yuan was undervalued against the dollar by 40.6% ((6.05-3.59)/6.05 = 40.6%)
Other uses of the Big Mac Index
Apart from deciding whether a currency is overvalued or undervalued, economists also use the Big Mac Index in different ways.
- UBS Wealth Management expanded the index by including the number of hours that an average worker must work to buy a Big Mac. This gives a more realistic picture of the purchasing power of the workers by including local wages.
- It can also be used to determine the rate of inflation by comparing the price of a Big Mac from different years. This is especially useful in countries where price indices are unreliable or unavailable.
- Other groups created separate PPP indices for goods such as Apple iPods and Starbucks coffees.
Flaws using this index
This index is produced for fun and never intended to be used seriously as there are many flaws:
There are differences between rents, labour costs and transportation costs in various countries. Also the raw ingredients often come across the borders, meaning they will be subject to added tax. Therefore, the price of a Big Mac varies widely between countries to reflect the difference in costs.
2. The price of a Big Mac depends on local demands. Some countries consume fewer Big Macs because of eating habits or cultural attitudes. In the US, McDonald’s is considered to be a cheap fast food, but in other countries, it is seen as an exotic foreign treat. McDonald’s will therefore use different marketing strategies to target different markets, causing the price of a Big Mac to vary.
– The nominal rate at which one country’s currency can be traded for another.
– When the general level of prices of goods and services in an economy is increasing.
Purchasing power parity
– This is when the exchange rate is adjusted to allow for accurate comparisons of purchasing power.