Big Mac Index

The Big Mac Index compares the prices of McDonald's Big Mac burgers, a fast food item produced and sold in 120 countries worldwide, as an indicator of possible overvaluation or undervaluation of the local currency relative to the U.S. dollar. The tongue-in-cheek analyses give an easily digestible example of the economic theory on purchasing power parity (PPP) and its applicability in the practical sense.

The Big Mac Index is based on the PPP theory, which holds that the price of a certain commodity should be the same in different countries and, if they are not so, that the exchange rate between the currencies of two countries will gradually adjust toward parity, or equality. This notion also extends toward an identical basket of goods and services. If the prices of all components of this basket are the same, then the PPP theory implies that the price for the basket should also be the same among countries.

If the price is not the same, the price difference (called arbitrage) between countries will encourage traders to buy the commodity in the lower-priced country and sell it for a profit in the other country with higher prices. The trade creates demand and induces commodity prices to rise in the lower-priced country; it also increases supply and influences prices [Page 145]to go down in the high-priced country, until the point is reached when no more price difference exists and there is no more profit to be made.

McDonald's standard items and outlets in cities like Bangkok made the Big Mac a lighthearted tool for comparing currencies.

The Big Mac Index uses the Big Mac burger as the reference commodity, or basket, consisting of its beef patties, cheese, lettuce, spices, and secret sauce on a bun studded with sesame seeds. The index takes the prices of the Big Mac burger in all 120 countries where it is available. The Big Mac PPP refers to the exchange rate that would make the prices of hamburgers in any of the 120 countries identical to prices in the United States (dollars). A currency would be considered undervalued or overvalued when its actual market exchange rate is compared with the Big Mac PPP.

For example, in the last annual publication (every July) of the index in 2007, the burger price in the United States was $3.41 (the average of prices in four cities: New York, Chicago, Atlanta, and San Francisco). In comparison, the same burger in the United Kingdom (UK) cost £1.99, which was equivalent to $4.00 at the prevailing market exchange rate of $2.01/£1. However, the implied Big Mac PPP is only $1.71 (actual U.S. price in dollars divided into actual UK price in pounds, i.e., $3.41/£1.99). Comparing the Big Mac PPP of $1.71 and the official exchange rate of $2.01, the UK pound has a 17.5 percent advantage and is thus overvalued against the dollar. It can be expected to depreciate in order to reach the PPP rate of £1=$1.71 from the existing £1=$2.01. Put another way, the burger is 17.5 percent more expensive in the UK than in the United States at the existing exchange rate, and is said to be 17.5 percent overvalued versus the dollar.

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