What is the Big Mac Index?

McDonald's as a Purchasing Power Parity Index

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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. And, what better basket of goods than McDonald's Big Mac - or at least its equivalent - in various countries?

In theory, the price of a Big Mac reflects a number of local economic factors, ranging from the cost of the ingredients to the cost of local production and advertising.

The resulting PPP metric is therefore considered by many economists to be a reasonable measurement of real world purchasing power. But investors should remember that there are some important exceptions to the rule.

How the Big Mac Index Works

The Big Mac Index is calculated by dividing the price of a Big Mac in one country by the price of a Big Mac in another country in their respective local currencies to arrive at an exchange rate. This exchange rate is then compared to the official exchange rate between the two currencies to determine if either currency is undervalued or overvalued according to the PPP theory.

For example, 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.

There are also many variants of the Big Mac Index that may be useful for investors. For instance, UBS Wealth Management expanded the index to factor in the number of hours that an average worker must work to earn enough to buy a Big Mac. Other groups created separate indexes for everything from Apple iPods to Starbucks coffees to Ikea Billy bookshelves.

The Consumer Price Index (CPI) - a key measure of inflation - seeks to include all kinds of goods. But, some economists believe that certain goods could provide a more accurate indicator since the CPI can be skewed by certain categories or manipulated by some governments. Of course, there is a similar drawback to using the Big Mac Index: It only includes a single item and lacks of the diversification seen in other economic indicators that factor in many different products and services.

Using the Big Mac Index

Investors in the United States may not see much need for the Big Mac Index, since there are already a number of reputable price indexes available, such as the Consumer Price Index (CPI). But the index becomes useful in other countries where reliable indexes aren't available, such as those that manipulate government statistics or those that don't publish official data. In these countries, investors may have trouble comparing consumer inflation to the exchange rate.

For example, many economists believed that Argentina had been modifying its official consumer price data to understate its true rate of inflation between 2010 and 2012. So, The Economist used its Big Mac Index to find that the average annual rate of burger inflation was 19% compared to the country's official 10% rate of inflation in January of 2011.

These insights could have helped international investors get a true idea of inflation when trying to value bonds or other inflation-sensitive securities.

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.

Inflation itself is extremely useful to know when it comes to valuing financial instruments. For example, bond yields must factor in anticipated rates of inflation to ensure that they're still attractive in the future. Inflation rates also impact currency valuations, which is important for both investors and politicians that grapple with whether tariffs or other trade barriers are justified.

In the end, international investors should use the Big Mac Index as just one of the many tools that their disposal when analyzing international markets.