A quick look at the Big Mac Index
By Amartya Menon
In 1986, Pam Woodall of The Economist introduced the Big Mac Index (BMI). In the words of The Economist, it is meant to be a lighthearted guide to determine whether currencies are at their ‘correct’ level. The index uses the price of a McDonald’s Big Mac burger, a standardised product with similar ingredients across the world, as a basis for determining the value of various currencies relative to the dollar.
The BMI is based on purchasing power parity, an economic theory that suggests that exchange rates must gradually move towards a rate whereby a particular basket of goods would cost the same in any two countries. The primary intention of the BMI is to make exchange rate theory easily comprehendible. By using the Big Mac as its central object, the index gives readers something that they can easily wrap their heads around.
Earlier this year, a Big Mac cost $7.76 (48 kroner) in Norway, $4.80 in the United States and $2.33 (24.50 rand) in South Africa. This means that the exchange rate necessary (or the implied exchange rate) to achieve purchasing power parity in Norway would be 48/4.80 = 10 kroner per dollar. In reality, the prevalent exchange rate at the time was 48/7.76 = 6.19 kroner to the dollar. In other words, according to the BMI, the Norwegian kroner was overvalued. Similarly, the South African rand had an implied exchange rate of 5.11 rand to the dollar whereas the actual exchange rate was 10.51 rand to the dollar, a gross undervaluing of the currency. The above examples highlight that the BMI is an accurate indicator of whether a currency is overvalued or undervalued relative to the dollar, and more importantly, a simplistic tool that is easily digestible for the layman.
Although the index tells us about where exchange rates ought to be heading, it tells us very little about the present day value of the currency. For this purpose, The Economist introduced an adjusted index that compares Big Mac prices to GDP per person in a particular country, giving us a better sense of what a currency’s purchasing power is relative to the general price level. Interestingly, the adjusted form of the index (adjusted for GDP per person) indicates that the Brazilian real is the most overvalued currency while the Hong Kong dollar the most undervalued currency. This compared to the raw index where the Norwegian kroner is the most overvalued currency while the Ukrainian hryvnia the most undervalued currency.
Inevitably, there are several problems with the Big Mac Index. To begin with, the cost of producing a Big Mac burger varies from country to country and even within countries. The cost of ingredients depends on import and export costs as well as taxes. Ingredients that are not indigenous to a particular nation will cost more. Import/export tax policy will also have large implications on the prices of ingredients. Furthermore, domestic labour and rent – factors whose costs vary from place to place – also have an impact on the price of the Big Mac. McDonald’s is a profitable business. Therefore, if local culture leaves room for price discrimination – an economic tool that allows businesses to charge different prices for the same product – it will definitely be taken advantage of. In countries like the United States, the Big Mac is a fast food, cheap and affordable. In developing countries such as India and Indonesia, this is not the case. The Big Mac is a luxury commodity. This difference in consumer perception allows McDonald’s to charge more for their food. The BMI fails to capture all of the above mentioned costs, realistically making Big Mac prices around the world incomparable. Last but most definitely not the least, there is the complicated problem of a country’s financial policy. Developing countries often choose to devalue their currencies in order to boost exports, build up foreign reserves and make themselves internationally competitive. This is a major dampener on the usefulness of the BMI.
Despite these seemingly large setbacks, the BMI has been used in several studies and continues to be used in economic textbooks around the world. There are several elements of the BMI that make it unique and interesting. The BMI is exceptionally useful when it comes to determining the erratic fluctuations in currency value, i.e. when a currency rapidly depreciates or appreciates. It is also a powerful measure of purchasing power. In fact, studies have shown that purchasing powering projections of the BMI are far more accurate than the predictions of the Consumer Price Index. On a lighter note, it allows us to estimate, albeit vaguely, how far our local currency will stretch in terms of purchasing power when we go abroad, making our travel decisions better informed.
Amartya Menon is an intern at the Takshashila Institution.