Is it possible that the price of burger can be an indicator of the global economy? According the The Economist, it is more than anyone can imagine. In 1986, The Economist invented the Big Mac Index as a jovial attempt to determine whether or not currencies were at their correct level. It’s based on a theory called the (PPP) purchasing-power parity. The Big Mac Index is based on the principal that, in the long run, exchange rates will move toward a rate that would equalize the prices of the same basket of goods (burger) in two countries. The following is an example. The average price of a Big Mac in the U.S.A. in 2013 was $4.37. In China it was $2.57 at market exchange rates. As a result of this analysis, the index tells us that the Yuan was undervalued by 41%.
This index was never meant to be an exact measurement or litmus test of currency misalignment. It was meant to be only a tool to make the exchange-rate analysis more easily understandable. Over time, it has become a global standard and included in some text books and an objective of many academic studies. Ryan Avant (chief economist at The Economist) states that it’s a loose way of gauging changes in the wages’ of workers to productivity ratio globally and to see if currencies are at an accurate level. Here’s an example to illustrate this further. If a Big Mac is more expensive in the U.S. than in Switzerland, then Swiss Franc is more than likely overvalued. This is true because these are similar products in these countries. It’s interesting to note that one can consider income differential. Furthermore, if one applies Big Mac prices, China’s currency is very close to a reasonable value in spite of all the rhetoric about the so called ‘currency manipulation’. As stated earlier, the Big Max index is based on the PPP, which will be discussed next but considering that many central banks are making an effort to brace up or degrade currencies in conjunction with the instability of the financial markets, Big Macs will never cost the same everywhere (Lyster, 2013). As a result of these findings I can’t place much faith in the Big Mac Index.
The Purchasing-Power Parity was developed in 1920 by Gustav Cassel. In essence, it states that in efficient markets the same goods and services should have only one price and is based on the ‘law of one price’ (Studyforex, n.d.). The theory is very important to the foreign exchange market. It’s the driving force that moves the currencies in the foreign exchange market. This is critical because it’s used to determine the cost of living from county to country. This is how the normal exchange rate is calculated. Traded goods are compared to non-traded goods in conjunction with the per capita gross domestic product method. By dividing the GDP, of a country, by the population, one can derive the per capita Gross Domestic Product. Then the two countries’ currencies can be tabulated. Consequently, many variables need to be accounted for such as interest rates, market speculation and hedging by central banks. All factors affect the true value of per capita Gross Domestic Product. Misleading results will occur and lead to an inaccurate measurement of the standard of living. Hence, the PPP method is used to create a more viable depiction.
PPP doesn’t mean that nominal exchange rates are constant or that they are equal to one. The theory suggests that there is an interaction between nominal prices and exchange rates in so much that items that sell in the U.S. for one dollar and a certain value of a Yen in Japan today. Hence this ratio would change respectively with the nominal exchange rate. Succinctly, PPP states that real exchange rates are always equal to one. To make it simpler, one item purchased domestically can be exchanged for one foreign item.
Regardless of its appeal, purchasing-power parity is not embraced in practice. The reason is that it relies on opportunities between cost and risk to buy items at a low price in one place and sell them at a higher price in another. This has the effect of bringing the price together in different countries. However there are other costs and barriers that effect transactions that place limits on the ability to enable prices to converge. They are the power of markets.
Regardless of these stated facts, PPP is a factor to consider as a starting point only in a theoretical scenario. Even though it might not be a perfect measurement, the insight behind it does hold some weight. It can however place everyday limits on how much actual prices can deviate across countries.
Beggs, J. (2013) Introduction of Purchasing-Power Parity. Retrieved from http://economics.about.com/od/Exchange-Rates/a/Introduction-To-Purchasing-Power- Parity.htm
Froeb, L. (2008). Managerial Economics. Mason, OH:South-Weston Cengage Learning
Hakkio, C. (n.d.). Is Purchasing Power Parity a Useful Guide to the Dollar? Retrieved from http://www.frbkc.org/PUBLICAT/EconRev/EconRevArchive/1992/3Q92hakk.pdf
Lyster, L. (2013). The Big Mac Index and Burgernomics. Retrieved from http://finance.yahoo.com/blogs/daily-ticker/big-mac-index-burgernomics- 145755381.html
Petryni, M. (2013). The Importance of Purchasing Power Parity. Retrieved from http://www.ehow.com/info_8425677_importance-purchasing-power-parity.html
Studyforex. (n.d.). Purchasing Power Parity. Retrieved from http://www.studyforex.com/purchasing-power-parity.html
The Economist. (2013). The Big Mac Index. Retrieved from http://www.economist.com/content/big-mac-index