What Is the Big Mac Index?

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DEFINITION

The Big Mac Index is an index based on the theory of purchasing power parity (PPP), which states that, in the long run, currency exchange rates should move toward equalizing the price of goods and services in different countries.

What Is the Big Mac Index?

The Big Mac Index is based on PPP theory, which 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. McDonald's has stores in 118 countries, which means its Big Mac sandwich can provide a useful control variable.

  • Alternate names: Big Mac PPP, Burgernomics

In theory, the price of a Big Mac is the result of many local economic factors, such as 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.

How to Calculate the Big Max Index

To figure out the Big Mac Index by comparing one country to another, you would divide the cost of a Big Mac in one country by the cost in another country. The answer will give you the PPP between one country and another.

Big Mac Index

How the Big Mac Index Works

A simple calculation reveals how the Big Mac Index works. You divide the price of a Big Mac in one country by the price of a Big Mac in another country. When you use 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 whether either currency is undervalued or overvalued. For example, suppose that a Big Mac in the U.S. costs $1, and in the eurozone it costs €2. The Big Mac Index valuation for EUR/USD would be 2. You would then compare this to the EUR/USD exchange rate. If the EUR/USD rate were 1.5, you might predict that the euro is undervalued by 0.5 euros per U.S. dollar. This calculation could impact many financial choices you make, such as where to invest your money.

Note

The Big Mac Index was developed in 1986 by The Economist, a publication focusing on economics, business, finance, and science.

As an investor, you can use the values to determine whether a currency is overvalued or undervalued relative to others. You can make trades based on comparing that data to the foreign exchange market.

You can also measure changes in values over time to show the rate of change in inflation and to compare to official records.

Limitations of the Big Mac Index

Investors in the U.S. might not see much need for the Big Mac Index. There are already many respected price indexes available, such as the Consumer Price Index (CPI), which seeks to include all goods to look at similar metrics.

The Big Mac index becomes useful in places where reliable indexes aren't available, perhaps due to manipulated government statistics or a lack of official, published data. In those countries, investors may have trouble comparing consumer inflation to exchange rates.

Tip

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 decisions about where to invest.

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%, 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.

While the CPI is a key measure of inflation, some economists 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, which means it lacks the diverse data seen in other economic indicators that include many different types of products and services.

Key Takeaways

  • The Big Mac Index is an index based on the theory of purchasing power parity (PPP).
  • Because Big Macs should be identical in every country, they provide a control variable for looking at price differences.
  • The Big Mac Index 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.
  • This method can be useful to apply to countries where reliable indexes or accurate official data aren't available.

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