Big Mac Index

Definition

The Big Mac Index is a purchasing power parity (PPP) index that uses the cost of a McDonald's Big Mac burger to compare the relative values of different currencies. It is a simple and accessible way to gauge the over or undervaluation of currencies around the world in relation to the US dollar.

5 Must Know Facts For Your Next Test

1. The Big Mac Index was created by The Economist magazine in 1986 as a lighthearted way to measure purchasing power parity between currencies.
2. It compares the local price of a Big Mac to its price in the United States, providing an informal measure of a currency's valuation.
3. Currencies that are undervalued will have a lower local Big Mac price compared to the US price, while overvalued currencies will have a higher local price.
4. The Big Mac Index is often used to gauge whether currencies are trading at their 'correct' level, with the goal of identifying currencies that are significantly under or overvalued.
5. While not a precise measure, the Big Mac Index can provide a quick snapshot of currency valuations and is a useful tool for comparing the relative strength of different economies.

Review Questions

• Explain how the Big Mac Index is used to compare the purchasing power of different currencies.
  • The Big Mac Index uses the price of a McDonald's Big Mac burger in different countries as a proxy for the overall price level in those economies. By comparing the local price of a Big Mac to its price in the United States, the index provides an informal measure of a currency's purchasing power and whether it is over or undervalued relative to the US dollar. Currencies with a lower local Big Mac price compared to the US price are considered undervalued, while those with a higher local price are seen as overvalued. This simple comparison gives a quick snapshot of the relative strength of different economies and can be used to gauge whether currencies are trading at their 'correct' exchange rate.
• Describe how the concept of purchasing power parity (PPP) relates to the Big Mac Index.
  • The Big Mac Index is based on the economic theory of purchasing power parity (PPP), which states that the exchange rate between two currencies should equalize the price of an identical basket of goods and services in those countries. By using the price of a Big Mac as a proxy for this basket, the index provides a tangible way to assess whether currencies are trading at their PPP level. If a currency is undervalued, the local Big Mac price will be lower than the US price, indicating the currency has greater purchasing power than the dollar. Conversely, an overvalued currency will have a higher local Big Mac price, suggesting it is trading above its PPP level. In this way, the Big Mac Index offers a simple test of PPP that can be applied across a wide range of economies.
• Evaluate the usefulness and limitations of the Big Mac Index as a tool for comparing economic conditions between countries.
  • The Big Mac Index is a widely-used and accessible metric for comparing the relative strength of different economies, but it also has significant limitations. On the positive side, the index provides a quick, easy-to-understand snapshot of currency valuations that can identify currencies that appear substantially under or overvalued. This can be a useful starting point for further analysis of economic conditions. However, the Big Mac Index relies on a single product price, which may not accurately reflect the broader price level in an economy. Additionally, factors such as taxation, subsidies, and labor costs can distort the local price of a Big Mac, making direct comparisons challenging. The index also does not account for differences in living standards, productivity, or other macroeconomic variables that influence a currency's true purchasing power. As such, the Big Mac Index should be viewed as a rough guide rather than a precise measure, with its results complementing rather than replacing more comprehensive economic analyses.

Related terms

Purchasing Power Parity (PPP): Purchasing power parity is an economic theory that states the exchange rate between two currencies should equalize the price of an identical basket of goods and services in those countries.

Exchange Rate: The exchange rate is the value of one currency in terms of another, or the rate at which one currency can be exchanged for another.

Inflation: Inflation is the general increase in the prices of goods and services in an economy over time, resulting in a decrease in the purchasing power of a given currency.