Purchasing power parity (PPP) is an economic theory that compares different countries' currencies through a "basket of goods" approach. According to this concept, two currencies are in equilibrium or at par when a basket of goods (taking into account the exchange rate) is priced the same in both countries (Mary Hall, 2018).
The index was created in 1986 by Pam Woodall, takes its name from the Big Mac, a hamburger sold at McDonald's restaurants (Big Mac Index, n.d.).
The Big Mac was chosen because it is available to a common specification in many countries around the world as local McDonald's franchisees at least in theory have significant responsibility for negotiating input prices. For these reasons, the index enables a comparison between many countries' currencies (Big Mac Index, n.d.).
The Big Mac Index serves as a benchmark and takes into account the views of people and looks at the correlation between income and the purchasing power of the people in a country (Akhbar Satar, n.d.).
The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (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 (Big Mac Index, n.d.).
Example 1
1) The price of a Big Mac was $3.57 in the United States (varies by store)
2) The price of a Big Mac was £2.29 in the United Kingdom (varies by region)
3) The implied purchasing power parity was $1.56 to £1, that is $3.57/£2.29 = 1.56
4) This compares with an actual exchange rate of $2.00 to £1 at the time
5) (2.00-1.56)/1.56 = 28%
6) The pound was thus overvalued against the dollar by 28%
(Big Mac Index, n.d.)
Example 2
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 (Justin Kuepper, 2018).
Example 3
Let’s say a Big Mac costs £3.19 in Britain and $5.51 in the United States – if you were to divide the local price in Britain by the US price, you’d get a Big Mac index exchange rate of 0.58. If you then compared it to the foreign exchange rate, which is 0.78 at the time of your analysis, it would indicate that the pound is undervalued by 29.4% (IG Analyst, 2018).
Investors can use data from the Big Mac Index in many different ways. For instance, they can use the values to determine if a currency is overvalued or undervalued relative to others and trade based on that data in the foreign exchange market. Similarly, investors can measure changes in values over time to determine rates of inflation and compare that to official records (Justin Kuepper, 2018).
Limitations
While economists widely cite the Big Mac index as a reasonable real-world measurement of purchasing power parity, the burger methodology has some limitations. In many countries, eating at international fast-food chain restaurants such as McDonald's is relatively expensive in comparison to eating at a local restaurant, and the demand for Big Macs is not as large in countries such as India and United States. Social status of eating at fast food restaurants such as McDonald's in a local market, what proportion of sales might be to expatriates, local taxes, levels of competition, and import duties on selected items may not be representative of the country's economy as a whole (Big Mac Index, n.d.).
In addition, there is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries: this is the theoretical reason for PPPs being different from market exchange rates over time (Big Mac Index, n.d.).
Nevertheless, McDonald's is also using different commercial strategies which can result in huge differences for a product. Overall, the price of a Big Mac will be a reflection of its local production and delivery cost, the cost of advertising, and most importantly what the local market will bear quite different from country to country, and not all a reflection of relative currency values (Big Mac Index, n.d.).
The Big Mac's price is decided by McDonald's Corp., which can significantly affect the Big Mac index. In some markets, a high-volume and low-margin approach makes most sense to maximize profit, while in others a higher margin will generate more profit. Thus the relative prices reflect more than currency values. For example, a hamburger costs only €1 in France, and €1.50 in Belgium, but overall, McDonald's restaurants are cheaper in Belgium. Prices of Big Macs can also vary greatly between different areas within a country. For example, a Big Mac sold in New York City will be more expensive than one sold at a McDonald's located in a rural area (Big Mac Index, n.d.).
Another limitation of the Big Mac Index is the geographical coverage. This is due to the presence of the McDonald's franchise. For example, in Africa McDonald's is only present in Morocco, Egypt and South Africa. There has been a similar index created solely for Africa called the KFC Index. As the name suggests, instead of using a Big Mac, this index uses KFC's Original 12/15 pc. bucket to compile its data (Big Mac Index, n.d.).
Manipulation
Critics of the presidency of Cristina Fernández de Kirchner in Argentina and many economists believe that the government has for years falsified consumer price data to understate the country's true inflation rate. The Economist stated in January 2011 that Big Mac index "does support claims that Argentina’s government is cooking the books. The gap between its average annual rate of burger inflation (19%) and its official rate (10%) is far bigger than in any other country." That year the press began reporting on unusual behavior by the more than 200 Argentinean McDonald's restaurants. They no longer prominently advertised Big Macs for sale and the sandwich, both individually and as part of value meals, was being sold for an unusually low price compared to other items. Guillermo Moreno, Secretary of Commerce in the Kirchner government, reportedly forced McDonald's to sell the Big Mac at an artificially low price to manipulate the country's performance on the Big Mac index. In June 2012, the price of the Big Mac value meal suddenly rose by 26%, closer to that of other meals, after The Economist, The New York Times, and other media reported on the unusual pricing (Big Mac Index, n.d.).
Comparison Issues
The Big Mac vary from country to country with differing nutritional values, weights and even nominal size differences. Not all Big Mac burgers offered by the chain are exclusively beef (Big Mac Index, n.d.).
In India which is a predominantly Hindu country beef burgers are not available at any McDonald's outlets. The Chicken Maharaja Mac serves as a substitute for the Big Mac (Big Mac Index, n.d.).
There is a lot of variance with the exclusively beef "Big Mac": the Australian version of the Big Mac has 22% fewer Calories than the Canadian version, and is 8% lighter than the version sold in Mexico (Big Mac Index, n.d.).
Edited by: 浪子
Bibliography
Big Mac Index. (n.d.). Retrieved from https://en.wikipedia.org/wiki/Big_Mac_Index
Justin Kuepper. (2018). What is the Big Mac Index? Retrieved from
https://www.thebalance.com/what-is-the-big-mac-index-1978992
Akhbar Satar. (n.d.). Big Mac Index Determines Level of an Economy. Retrieved from
http://www.focusmalaysia.my/Columns/big-mac-index-determines-level-of-an-economy
IG Analyst. (2018). What is the Big Mac Index? Retrieved from
https://www.ig.com/au/trading-opportunities/what-is-the-big-mac-index-180905
Mary Hall. (2018). What is Purchasing Power Parity (PPP)? Retrieved from
https://www.investopedia.com/updates/purchasing-power-parity-ppp/
Big Mac Index
Reviewed by 浪子
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October 14, 2018
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Reviewed by 浪子
on
October 14, 2018
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