The Big Mac Index is an index based on the theory of purchasing power parity (PPP). PPP theory states that, in the long run, currency exchange rates should move toward equalizing the price of goods and services in different countries.
This is often expressed with the phrase "a basket of goods and services." But to look at the theory, you need something that is really the same in every country.
That's where the "Big Mac" part of the name comes in. A McDonald's Big Mac is a "basket of goods" with the same ingredients in almost every country where it is made.
Learn more about the Big Mac Index and what it can tell you about purchasing power, local and world economics, and inflation.
What Is the Big Mac Index?
The Big Mac Index is based on PPP theory. This theory looks at the idea of an identical basket of goods and services in different countries.
A basket of goods and services in the U.S. will often look different from what you can find in other parts of the world. But McDonald's has stores in 118 countries. This means its Big Mac burger can provide a useful control variable.
In theory, the price of a Big Mac is the result of many local economic factors. This could be the price of the ingredients, local wages, or how much it costs to put up billboards and buy TV ads.
These variables are what make the Big Mac Index so valuable. Many economists find that the PPP metric you can get from comparing the prices of Big Macs around the world is a reasonable measure of real-world purchasing power.
- Alternate names: Big Mac PPP, Burgernomics
How the Big Mac Index Works
The Big Mac Index is simple to calculate. You divide the price of a Big Mac in one country by the price of a Big Mac in another country. By using the local currency for each one, you end up with an exchange rate.
Then, compare this exchange rate to the official exchange between the two currencies. According to PPP theory, this will show you if either currency is undervalued or overvalued.
For example, suppose that a Big Mac in the U.S. costs $1, and a Big Mac in the eurozone costs €2. The Big Mac Index valuation for EUR/USD would be 2.0, or two divided by one.
You would then compare this to the EUR/USD exchange rate. If the EUR/USD rate was 1.5, you might predict that the euro is undervalued by 0.5 euros per U.S. dollar.
This could impact many financial choices you make, such as where to invest your money.
The Big Mac Index was developed in 1986 by The Economist. This is a publication focusing on economics, business, finance, arts, and science.
Variations of the Big Mac Index
There are many variants of the Big Mac Index. Each can be useful for investors.
UBS Wealth Management expanded the index to look at earning power. Their index factors in the number of hours that most workers must work to earn enough to buy a Big Mac.
Other groups made indexes for other items that can be purchases in multiple countries and are mostly the same in each one. These include Apple iPods, Starbucks coffees, Ikea Billy bookcases, and more.
The Consumer Price Index (CPI) is a key measure of inflation. It seeks to include all goods to look at similar metrics. Some economists, though, believe that certain goods can provide a more accurate indicator. The CPI, they argue, can be skewed by certain categories or manipulated by some governments.
There is a similar drawback to using the Big Mac Index. It only includes a single item. This means it lacks the diverse data seen in other economic indicators that include many different types of products and services.
The Big Mac Index as an Investigative Tool
Investors in the U.S. may not see much need for the Big Mac Index. There are already many respected price indexes available, such as the CPI.
But the index becomes useful in places where reliable indexes aren't available. This might be due to manipulated government statistics or a lack of official, published data. In these countries, investors may have trouble comparing consumer inflation to the exchange rate.
Between 2010 and 2012, many economists believed that Argentina was modifying its official consumer price data to understate its true rate of inflation. The Economist used the Big Mac Index to find that the average annual rate of burger inflation was 19%.
This was much higher than the country's official 10% rate of inflation from January 2011. These insights could have helped international investors get a true idea of inflation when trying to value bonds or other securities that respond to inflation.
Why the Big Mac Index Is Useful
Investors can use data from the Big Mac Index in many ways.
They can use the values to determine if a currency is overvalued or undervalued relative to others. Then, they can make trades based on comparing that data to the foreign exchange market.
Investors can also measure changes in values over time. This can show the rate of change in inflation and be useful to compare to official records.
The Big Mac Index is useful, but it is just one tool. Investors should use it along with other ways of analyzing international markets before making any choices about where to invest.
Inflation itself is extremely useful to know when it comes to valuing financial instruments. For example, bond yields must factor in the anticipated rates of inflation. This ensures that they will remain attractive in the future.
Inflation rates also impact currency valuations. This is important for politicians when deciding whether to use tariffs or other trade barriers.
- The Big Mac Index is an index based on the theory of purchasing power parity (PPP).
- Because a Big Mac should be identical in every country, it provides a control variable for looking at price differences.
- It is used by dividing the price of a Big Mac in one country by the price of a Big Mac in another country in their local currencies to arrive at an exchange rate.
- It can be useful in countries where reliable indexes or accurate official data aren't available.