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February 10, 2005
Real Big Mac Value
Looking to invest globally? Let the Big Mac be your guide.
The Big Mac index is an informal way of measuring whether one currency is at the theoretically correct exchange rate with another currency. The measure assumes that the theory of purchasing power parity (PPP) holds.
The main tenet of PPP is that the exchange rate between two currencies should naturally adjust so that the cost of a sample basket of goods should cost the same in one currency. In the Big Mac index, the "basket" in question is considered to be a single Big Mac as sold by McDonald's. The Big Mac was chosen because it is available to a common specification in many countries around the world, with local McDonald's franchisees having significant responsibility for negotiating input prices. For these reasons, the index allows for meaningful comparison between many countries' currencies.
The Big Mac PPP exchange rate between two countries is obtained by dividing the cost of a Big Mac in one country (in its own currency) by that of a Big Mac in another country (likewise in its currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued compared with the second, and conversely, if it is higher, then the first currency is over-valued.
For example, suppose a Big Mac costs £2.00 in the United Kingdom and $2.50 in the United States; thus, the PPP rate is 2.00/2.50 = 0.8. If, in fact, the dollar buys £0.55, then the pound is over-valued with the respect to the dollar.
The Big Mac index was introduced by The Economist newspaper in 1986 and has been published by them regularly since then. The index also gave rise to the word Burgernomics.
To get the latest Big Mac data, you can find it on the Economist site here:
In January 2004, The Economist introduced another index, the Tall Latte Index. The idea is the same, except that the Big Mac is replaced by a cup of Starbucks coffee, acknowledging the global spread of that chain in recent years. In a similar vein, in 1997, they created a Coca-Cola map that showed a strong positive correlation between the amount of Coke consumed per capita in a country and that country's wealth.
The burger methodology has limitations in its estimates of the PPP. For example, local taxes, rates, levels of competition, and import duties for burgers may not be representative of the country's economy as a whole. Nevertheless, the Big Mac index has become widely cited by economists.
However, a major problem with such indices is that they completely omit to take into account historical differences. i.e. convenience food in many parts of Europe has a higher “perceived value” than in the USA – indeed the same applies to many items sold in shops (possibly related to the different values nations place upon labor).
So, for example, the typical difference (specifically, the median) has been for Big Macs in Britain to be 19% more expensive than in the States. So the fact that a Big Mac costs 20% more in the UK right now doesn't mean Britain's pound is 20% overvalued. It's about in line with history - which is NOT what most experts would tell you right now!
And yet --
Latest data published by The Economist indicates that the cheapest burger is in China, at $1.26, compared with an average American price of $3. This implies that the yuan is 58% undervalued relative to its Big Mac dollar-PPP. On the same basis, the euro is 25% overvalued, the yen 17% undervalued.
I'll leave you to draw your own conclusions!
Posted by Tony at February 10, 2005 03:19 PM
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