The Big Mac index is an informal way of measuring the purchasing power parity (PPP) between two currencies. By comparing the price of a McDonald’s hamburger in the US versus other countries, traders can establish the disparity between the purchasing power of the nations’ currencies. This can help establish whether a currency is over or undervalued. We explain why ‘burgernomics’ is useful for traders, and how you can calculate the Big Mac currency index.
Becca Cattlin
Financial writer, London
Publication date : 2018-09-05T16:35:00+0100
Source: Bloomberg
What is purchasing power parity?
Purchasing power parity (PPP) is a theory of exchange-rate determination.
It proposes that the price of a bundle of goods in one country should be equal to the price of that same bundle of goods in another country, once their currencies have been adjusted for the exchange rate. For example, suppose that the current exchange rate between Canada and the United States is 1.3 to 1, meaning that you’d need 1.30 Canadian dollars to buy one US dollar. If we assume that PPP exists between these two nations, then a basket of goods that is worth $10 in the U.S. should cost $13 in Canada.
PPP is used to determine how much the rate of exchange between two paper currencies impacts what consumers pay for daily goods and services.
PPP theory suggests that, in the long run, the exchange rate between two currencies should move toward a point of conversion – so that the prices of identical goods and services become the same. If there is a lasting disparity between the prices of a basket of identical goods across different countries, then it could create an opportunity for items to be bought in the country that sells it for the lowest price.
The Big Mac index
The Big Mac index takes PPP theory and narrows it down to a specific good: a McDonald’s hamburger. The idea is that if we compare each country’s price of a Big Mac against the US dollar, and calculate the Big Mac index exchange rate, we can establish whether currencies are over or undervalued against the dollar.
The index was invented by The Economist in 1986, as a light-hearted measure of purchasing parity power.1 However, since its creation it has become used as a global standard of currency misalignment and is now published annually.
If the theory of purchasing power parity holds true, then the price of a Big Mac should be identical in every country. If discrepancies are found, the theory would imply that the market will gradually correct itself and converge upon the same price point.
The concept of using hamburgers as an economic measure has become extremely popular, earning itself the title of ‘burgernomics’. For example, the UBS Wealth Management and the Council of European Municipalities and Regions (CEMR) expanded the Big Mac index to look at how long the average employee in each country would have to work on minimum wage in order to buy a Big Mac.2
The Economist has even produced variations of the Big Mac index, such as the Tall Latte index, which replaced the Big Mac with a Starbucks coffee.3 Similarly, Bloomberg ran a Billy index, which converted the local prices of IKEA’s Billy bookshelf into US dollars and then compared the prices.
How to calculate the Big Mac index
To calculate the Big Mac index, you divide the price of a Big Mac in one country (in its local currency) by the price of a Big Mac in the US, to arrive at an exchange rate. You would then compare this exchange rate to the official foreign exchange rate to determine whether the currency is over or undervalued against the US dollar.
Let’s say a Big Mac costs £3.19 in Britain and $5.51 in the United States – if you were to divide the local price in Britain by the US price, you’d get a Big Mac index exchange rate of 0.58. If you then compared it to the foreign exchange rate, which is 0.78 at the time of your analysis, it would indicate that the pound is undervalued by 25.6% (the difference between those two exchange rates).
Why should traders use the Big Mac index?
The Big Mac index is considered useful to forex traders who are seeking to establish a currency’s long-term forecast and exchange rate evaluation. If there is a disparity between the Big Mac index rate, and the actual exchange rate, then it can be used as an indicator of a future correction of the forex rate. In essence, PPP and the Big Mac index can help traders establish a connection between goods and forex, and can act as a guide for where the market might move.
There are a range of other indices that are designed to measure consumption, such as the consumer price index (CPI) in the US, and the UK’s consumer price inflation index. However, the Big Mac index becomes useful for comparing prices in countries that do not have a similar measure of economic health. McDonald’s is the world’s largest restaurant chain, with over 34,480 restaurants in 119 countries, so it’s easy to understand why its hamburger has been put forward as a global indicator. It is also assumed that Big Macs are the same all over the world, because in theory they are standardised in size, quality and ingredients.
However, it is worth remembering that theory does not always line up with reality. The price of a McDonald’s hamburger can be influenced by a range of economic factors, not just exchange rates. These include production and labour costs, advertising, availability, and untradeable inputs such as rent and wages, as well as the ingredients themselves – for example, in India a Big Mac is made from chicken instead of beef for cultural reasons. It is also important to note that Big Mac prices are set by McDonald's Corp (MDC).
The Big Mac index provides traders with a long-term view of a possible market correction, but it does little to address current or short-term fluctuations that are of interest to a lot of forex traders. This is why the Big Mac index should be used as just one analysis tool, alongside technical and fundamental analysis. While technical analysis uses historical price data to predict which market movements are likely in the future, fundamental analysis looks at macroeconomic data and derives a forecast from valuations, financial news and information on the specific asset.
Theories of exchange rate determination
Other theories of exchange rate determination aim to identify relationships between global currencies, specifically looking at how equilibrium between two currencies is achieved and why the exchange rate moves up and down. There are a range of exchange rate theories, including:
- Interest rate parity (IRP): the theory that there is a link between the nominal interest rate of two countries and the exchange rate between their currencies
- International fisher effect(IFE): the theory that the exchange rate should change by a similar amount to the difference between the countries’ nominal interest rates
- Balance of payments: a theory that looks at a country’s inflows and outflows of goods. If there is a deficit or surplus, it suggests that the exchange rate will adjust to bring the balance of payments to an equilibrium.
- Real interest rate differentiation: a model which states that a country with a higher real interest rate will see its currency appreciate against other countries with lower interest rates
Discover technical and fundamental analysis tools
Learn more about using technical and fundament analysis with
IG Academy’s range of online courses, webinars and seminars.
Learn more
Share this article
