What is the Big Mac Index?

Definition

The Big Mac Index is an index based on the theory of Purchasing Power Parity (PPP), which states that exchange rates should move towards the equilibrium price of goods and services in different countries in the long run.

What is the Big Mac Index?

The Big Mac Index is based on the theory of Purchasing Power Parity (PPP), which considers the idea of a matching basket of goods and services in different countries. The basket of goods and services in the United States might be different from what you can find in other parts of the world. McDonald’s has stores in 118 countries, which means that its Big Mac can provide a useful control variable.

How to Calculate the Big Mac Index

To calculate the Big Mac Index by comparing one country to another, you need to divide the cost of a Big Mac in one country by its cost in another country. The answer will give you the Purchasing Power Parity between the two countries.

How the Big Mac Index Works

A simple calculation reveals how the Big Mac Index works. You need to divide the price of a Big Mac in one country by its price in another country. Using the local currency for each, you will get an exchange rate. Then compare this rate to the official exchange rate between the two currencies. According to the theory of Purchasing Power Parity, this will show you whether one currency is undervalued or overvalued. For example, suppose the price of a Big Mac in the United States is $1, and in the Eurozone, it is €2. The value of the Big Mac Index for the EUR/USD currency pair would be 2. You can then compare this to the EUR/USD exchange rate. If the EUR/USD exchange rate is 1.5, you might expect that the euro is valued at €0.5 for every US dollar. This calculation can influence many financial decisions you make, such as where to invest your money.

Limitations of the Big Mac Index

Investors in the United States may not see the Big Mac Index as highly necessary. There are several respected price indices available, such as the Consumer Price Index (CPI), which seeks to include all goods to consider similar measures. The Big Mac Index becomes useful in places where reliable indices are not available, possibly due to manipulation of government statistics or the absence of official published data. In such countries, investors may face difficulties in comparing consumer inflation to exchange rates.

Advice

The Big Mac Index is useful, but it is just one tool. Investors should use it alongside other methods of analyzing international markets before making any decisions about where to invest.

Between 2010 and 2012, many economists believed that Argentina was adjusting its official consumer price data to lower the real inflation rate. The Economist magazine used the Big Mac Index to find that the average annual inflation rate for burgers was 19%, much higher than the country’s official inflation rate of 10% as of January 2011. These insights can help international investors gain a real sense of inflation when trying to assess bonds or other securities that respond to inflation.

While the Consumer Price Index (CPI) is a key measure of inflation, some economists believe that certain goods can provide a more accurate gauge. They argue that the Consumer Price Index can be influenced by certain categories or can be manipulated by some governments.

There is a similar drawback in using the Big Mac Index. It includes only one item, meaning it lacks the diverse data found in other economic indices that encompass many different types of products and services.

Source:

https://www.thebalancemoney.com/what-is-the-big-mac-index-1978992

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