Question

How can the Big Mac Index be used to compare exchange rates? Discuss.

Answer 1

The Big Mac Index is an index created by The Economist based on the theory of purchasing power parity (PPP). Over the long-term, PPP theory states that currency exchange rates should equal the price of a basket of goods and services in different countries.

The Big Mac index suggests that, in theory, changes in exchange rates between currencies should affect the price that consumers pay for a Big Mac in a particular nation, replacing the "basket" with the popular hamburger.

For example, if the price of a Big Mac is $4.00 in the U.S. as compared to £2.5 in Britain, we would expect that the exchange rate would be 1.60 (4 ÷ 2.5 = 1.60). If the exchange rate of dollars to pounds is any greater, the Big Mac Index would state that the pound was overvalued; any lower and it would be undervalued.

Another suppose that a Big Mac in the U.S. costs one U.S. dollar and one in the eurozone costs two euros. The Big Mac Index valuation for EUR/USD would be 2.0, or two divided by one, which could then be compared to the EUR/USD exchange rate. If the EUR/USD exchange rate was 1.5, investors might predict that the euro is undervalued by 0.5 euros per U.S. dollar.

The index is imperfect at best. First, the Big Mac's price is decided by the McDonald’s Corp. (MCD) and can greatly affect the Big Mac index. Also, the Big Mac differs across the world in size, ingredients and availability. That being said, the index is meant to be light-hearted.