How 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 "twoallbeefpattiesspecialsaucelettuce
cheesepicklesonionsonasesameseedbun," 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.
- 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.
Purchasing Power Parity
Economists refer to purchasing power parity to describe why, over time, the dollar price of a good in one country should equal its dollar price in all other countries. While this theory naturally relies on certain assumptions (such as negligible transportation costs, that goods and services must be "tradable," and that a good in one country does not differ substantially from the same good in another country) it is intuitively appealing. The notion that a particular type of cordless telephone should sell for the same dollar price in the United States as it does in, say, Japan and Great Britain, makes sense if you think about supply and demand in world markets. Suppose that the telephone sells for $29.99 in the United States, 2500 yen in Japan, and 25 pounds in Great Britain.
- In which country is the dollar price of the cordless phone the lowest? See Currency Converter
- What is the exchange rate between the Japanese yen and the United States dollar?
- What is the exchange rate between the British pound and the United States dollar?
- What is the dollar price of the cordless phone in Japan?
- Calculate the price of the cordless phone in Great Britain.
- In which country is the dollar price of the cordless phone the lowest?
- In which country is the dollar price of the cordless phone the highest?
Purchasing power parity suggests that an entrepreneur could earn profits by purchasing cordless phones in Japan and selling them to consumers in Great Britain and the United States. This should cause the price of cordless telephones to rise in Japan (because, with increased exports to other countries, the demand for Japanese cordless phones would increase). Conversely, cordless phone prices in the United States and Great Britain will likely fall because of an increased supply (arising from more Japanese imports) of cordless phones. Purchasing power parity theory suggests that price adjustment will continue until the dollar price of cordless phones is the same in each country. In our example, assuming given exchange rates, the yen price may rise to 2,835 yen, the dollar price may decline to $26.95, and the pound price may decline to 16.68 pounds.
- Is the dollar price of cordless phones equalized across the three countries at the new yen and pound prices?
This price equalization is an example of purchasing power parity. Note that it works best for close substitutes that can be traded among countries over long periods of time.
The Big Mac Index
While the Big Mac is not strictly tradable between countries, it is sold to consumers in 116 countries around the world. It is a truly global consumer product. Since 1986, The Economist magazine has tracked the price of the Big Mac around the world. Information about local Big Mac prices has been combined with foreign exchange rates to serve as an unscientific indicator of future movements in currency exchange rates. Purchasing power parity theory is applied to the current dollar price of Big Macs in countries around the world to determine the extent to which currencies are over- or under-valued.
Here you will find a variety of past articles about the Big Mac index. Click on the April 3rd 1999 hyperlink titled "Our Big Mac Index"
Note the table titled "the hamburger standard." Listed across the columns of the table are:
- The country
- The Big Mac price in local currency
- The Big Mac price in dollars (this is the Big Mac price in local currency, column 2, divided by the actual dollar exchange rate, column 5)
- The implied purchasing power parity (PPP) of the dollar (this is the Big Mac price in local currency, column 2, divided by $2.43, the United States price of the Big Mac)
- The actual exchange rate on March 30, 1999
- The percentage under or over valuation of the currency against the dollar (this is the percentage difference between the implied PPP in column 4 and the actual dollar exchange rate in column 5)
While the example of trade in cordless telephones used to describe purchasing power parity in the previous section assumed that domestic and foreign prices would adjust to ensure PPP, the Big Mac index assumes that Big Mac prices are constant and the dollar exchange rate will adjust to restore PPP. So, for example, if we compare the 17.50 franc cost of a Big Mac in France to the franc-dollar exchange rate of 6.10, this suggests that it would cost $2.87 to purchase a Big Mac in France. This indicates that the Franc might be over-valued. That is, for the dollar cost of the Big Mac in France to equal the price of the Big Mac in the United States (assuming French and United States Big Mac prices remain unchanged), the dollar would need to appreciate to 7.20 francs per dollar. When the amount of currency that a dollar can purchase increases, the dollar is said to have appreciated.
Alternatively, we can think of the franc needing to depreciate for United States and French Big Mac prices to equalize. A currency is said to depreciate when it purchases less foreign currency. In our case, if the franc-dollar exchange rate went from 6.10 to 7.20, it would be more costly for the French to purchase dollars. The franc would have thus depreciated.
In the last column of the table, you can see that the Big Mac index suggests that some currencies are under-valued while others are over-valued. For example, the dollar in March 1999 could purchase over 8 Chinese yuan. In order for PPP to hold, the dollar should only have been able to purchase slightly over 4 yuan. This suggests that the yuan is under-valued by 51 percent relative to the dollar, indicating that the yuan would be expected to appreciate in the future. Conversely, the German mark was 12 percent over-valued relative to the dollar, indicating future mark depreciation.
Big Mac Index Activity
Your assignment is to determine whether assorted currencies are under or over valued against the dollar. Using the Big Mac prices reported in "the hamburger standard" table, fill in the missing blanks of the table below. Use current currency rates from Currency Converter
Note: once you have determined the country to enter in each row of the first column, enter the Big Mac prices in local currency in column 2. Enter the current exchange rates in column 5, and divide the local price of the Big Mac by the current exchange rate to find the dollar price of the Big Mac. The implied PPP in column 4 is the same as reported in "the hamburger standard" table. Compute the percentage difference between the implied PPP and the actual exchange rate to determine the extent to which the currency is currently over or under valued.
So, what’s the catch? You need to determine the country to be entered into the various rows by pairing it with its national capital. Each capital corresponds to a country in "the hamburger standard" table. If you have difficulty determining the country for a listed capital city, see "Country Listing" in the "CIA World Factbook"
Hint: Go to the "government" link for any given country that is hyperlinked in "Country Listing." The first entry has been completed for you. When you are finished look at the first letters of each of the countries, starting with Australia, and you will see the name of a very famous economist spelled out.
- Buenos Aires
- Mexico City
- Kuala Lumpur
Big Mac Index
|Country||Local Big Mac Price in Local Currency||Local Big Mac Price in Dollars||Implied Purchasing Power Parity of the Dollar||Current Actual Dollar Exchange Rate||Percentage Under(-) or Over(+) Valuation Against the Dollar|
- What is the most over-valued of the above currencies?
- By how much does your Big Mac index indicate that this currency is over-valued?
- What is the most under-valued of the above currencies?
- By how much does your Big Mac index indicate that this currency is under-valued?
- Which currency is closest to PPP?
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!