The Big Mac Index

EDUCATOR'S VERSION

This lesson printed from:
http://www.econedlink.org/e156

Posted November 30, 1999

Standard: 7

Grades: 9-12

Author: Rich MacDonald

Posted: November 30, 1999

Updated: March 24, 2014

DESCRIPTION

How fast can you say "twoallbeef-pattiesspecialsauce-lettucecheesepickles-onionsonasesameseedbun?" This question was asked of millions of TV viewers in the now famous 1970s McDonald's television commercial promoting the Big Mac.

KEY CONCEPTS

Characteristics of Money, Currency, Exchange Rate, Price

STUDENTS WILL

  • Explain that over long periods of time, the dollar price of specific goods and services should equalize across countries.
  • Explain that current deviations from purchasing power parity may help explain future exchange rate movements.
  • Explain that when foreign exchange rates between countries change, the relative prices of goods and services between those countries also change.

INTRODUCTION

 BurgerHow fast can you say "twoallbeefpattiesspecialsaucelettuce
cheesepicklesonionsonasesameseedbun?" This question was asked of millions of TV viewers in the now famous 1970s McDonald’s television commercial promoting the Big Mac. The Big Mac, perhaps the world’s most popular sandwich, was created in 1968 by a McDonald’s franchisee in Pittsburgh, Pennsylvania. Click here for a digital picture of the Big Mac. While most people see the Big Mac as "twoallbeefpattiesspecialsaucelettucecheesepicklesonionsonasesameseedbun," economists also see the sandwich as a consumer good that is sold at over 25,000 McDonald’s restaurants in 116 countries around the world. Because of its popularity, the Big Mac allows economists to make (admittedly unscientific) comparisons of exchange rates and relative prices in countries around the globe. This EconomicsMinute looks at how the "Big Mac Index" helps explain variation in exchange rates and prices.

RESOURCES


PROCESS

Purchasing Power Parity

  1. In which country is the dollar price of the cell phone the lowest?[The answer to this depends on current foreign exchange rates. See Currency Converter ]
  2. What is the exchange rate between the Japanese yen and the United States dollar?[This answer varies by the hour, but on July 6, 2016 the exchange rate was 101.3 yen per dollar.]
  3. What is the exchange rate between the British pound and the United States dollar? [This answer varies by the hour, but on July 6, 2016 the exchange rate was 0.773 pounds per dollar.]
  4. The dollar price of the cell phone in Japan is $177.69. This is calculated by dividing 18000 yen by the yen-dollar exchange rate of 101.3 yen per dollar.
  5. Calculate the price of the cell phone in Great Britain. [$232.86 Note that this is calculated by dividing the assumed 180 pound price in Great Britain by the pound-dollar exchange rate of 0.773 pounds per dollar.]
  6. In which country is the dollar price of the cell phone the lowest?[Japan]
  7. In which country is the dollar price of the cell phone the highest?[Great Britain]

http://i.huffpost.com/gen/1698980/images/o-WOMAN-TALKING-ON-THE-PHONE-facebook.jpgPurchasing power parity suggests that an entrepreneur could earn profits by purchasing cell phones in Japan and selling them to consumers in Great Britain and the United States. This should cause the price of cell phones to rise in Japan (because, with increased exports to other countries, the demand for Japanese cell phones would increase). Conversely, cell phone prices in the United States and Great Britain will likely fall because of an increased supply (arising from more Japanese imports) of cell phones. Purchasing power parity theory suggests that price adjustment will continue until the dollar price of cell phones is the same in each country. In our example, assuming given exchange rates, the yen price may rise to 18,837 yen, the dollar price may decline to $185.95, and the pound price may decline to 143.74 pounds.

8. Is the dollar price of cell phones equalized across the three countries at the new yen and pound prices?[Yes. The new dollar price in Japan is $185.95, 18,837 yen divided by 101.3 yen per dollar. The new dollar price in Great Britain is $185.95, 143.74 pounds divided by 0.773 pounds per dollar.]

CONCLUSION

Purchasing power parity is best thought of as a long run theory of exchange rate determination. The Big Mac is not a tradable good and its price does vary between locations in any given country. This means that the Big Mac Index is likely to prove an imperfect indicator of future exchange rate movements. Despite this, it will be interesting for you to follow the exchange rates in your index in coming months to see if over-valued currencies do indeed depreciate and under-valued currencies appreciate. Perhaps the next time you order a Big Mac you should offer to pay in Chinese yuan!