by Pierre Chalon
Some of you may be familiar with the numbers that often appear on television, websites or magazines regarding exchange rates, what they mean and what are their implications. If you’ve taken a course like International Economics or International Finance, this subject is one you’re likely to recognize.
Up until a few months ago, exchange rates and any statistics related to them meant very little to me. The Big Mac Index is a component of a little theory called “purchasing-power parity” (PPP) that may help you make some sense of something like:
£1 buys change % 52 wk-h 52 wk-l
Euro 1.18100 +0.00070 +0.06 1.21280 1.10650
The theory suggests that that in the long run, exchange rates should move towards the level where the price of an identical basket of goods or services bought in two countries is the same. That point is known as the PPP exchange rate. These baskets of goods vary for every country depending on consumer preferences and spending patterns (what constitutes these baskets has often been a source of disagreement).
Here’s the interesting part. To simplify this theory and make it more accessible to people not necessarily knowledgeable about currency fluctuations, in 1986, The Economist magazine published the “Big Mac Index”, essentially a data table with prices of a single Big Mac burger in many countries in local currencies. The idea was to make the basket of goods merely a McDonald’s Big Mac burger so as to determine whether currencies were being over or under valued. How? Let me give an example. Let’s say the average Big Mac in America costs US$3.22 and 509 Kronur in Iceland (US$ 7.22 at the market exchange rate). This implies a PPP of 158 Kronur for a dollar (where they would equalize). We then compare the exchange rate of the currencies to the cost of a Big Mac to see where it would be cheaper overall to buy it. In this case, the actual dollar exchange rate is 68.4, meaning that the Icelandic krona is currently being over-valued by 131% and it should (in theory), depreciate against the US dollar.
Even though The Economist has stated many times that this indicator should not be taken seriously, many people closely follow the data given, as some believe it has currency fluctuation predicting capabilities. Over its twenty-year existence, the Big Mac index has come under a lot of scrutiny for its simplicity, but the magazine remains firm on their view that the data produced should not be interpreted extensively, that it is a simpler way of viewing PPP theory and has been continually publishing it several times a year. There is no doubt that its popularity stems from its simplicity and there have been other attempts that similarly dumb down the theory (i.e. the “IPod Index”).
Whether it is capable of predicting future trends in exchange rates is questionable but the Big Mac Index remains a useful (and tasty) modern economic theory that helps you understand currency fluctuations.