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.
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 “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.
- 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.
- Bloomberg: At this website you can find Cross-currency Rates.
- Our Big Mac Index: Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries.
- The Economist’s Big Mac Index: Here you will find an interactive graphic about the Big Mac Index.
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 cell phone 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 cell phone sells for $199.99 in the United States, 18,000 yen in Japan, and 180 pounds in Great Britain.
- 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 ]
- 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.]
- 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.]
- 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.
- 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.]
- In which country is the dollar price of the cell phone the lowest?[Japan]
- In which country is the dollar price of the cell phone the highest?[Great Britain]
Purchasing 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.]
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 Economistmagazine 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.
The website is an interactive tool that allows you to compare the prices of Big Mac Burgers purchased in various countries around the world. There are a number of colored countries shown on the map. Putting your mouse over a country gives you a list of information about Big Macs sold there including:
- The country
- The Big Mac price in local currency
- The Big Mac price in dollars (this is the Big Mac price in local currency, shown in parentheses, divided by the actual dollar exchange rate)
- The Raw Index, which tells you how much a currency is over or undervalued compared to the dollar based on Big Mac Prices.
- The actual exchange rate on January 2016
- The Implied Exchange Rate, which is the price of the burger in local currency divided by the January 2016 price in dollars ($4.93).
While the example of trade in cell phones 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.
To get a better understanding of the graphic, let’s look at India and its valuation of the Big Mac. The local currency is the Rupee and a Big Mac costs 127 Rupees there. In January 2016, the Dollar-Rupee exchange rate was 1 dollar-66.8 Rupees. So the Big Mac cost in US dollars is equal to 127/66.8 = $1.90. However, this dollar price is only equal to 0.385 or 38.5% of the cost of a Big Mac in the US. So the Rupee is 61.5% undervalued in January 2016. To find the implied exchange rate, we assume that the cost of a Big Mac in Rupees and dollars is equal. So $4.93 = 127 Rupees, or $1 = 25.76 Rupees.
Based on our example with India, comparing the 127 Rupee cost of a Big Mac to the Rupee-Dollar exchange rate of 66.8 suggests that it would cost $1.90 to purchase a Big Mac in India. This indicates that the Rupee might be undervalued. For the dollar cost of a Big Mac in India to be equal to the price of a Big Mac in the United States (assuming prices in each country do not change), the dollar would need to depreciate to 25.76 Rupees. When the amount of currency that a dollar can purchase decreases, the dollar is said to have depreciated. In this example, the amount a dollar can purchase drops from 66.8 to 25.76 Rupees.
Alternatively, we can think of the Rupee needing to appreciate for the United States and Indian Big Mac prices to equalize. A currency is said to appreciate when it purchases more foreign currency. In this example, if the Rupee-dollar exchange rate went from 66.8 to 25.76, it would be less expensive for the Indians to purchase dollars. Thus, the Rupee would have appreciated.
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 January 2016 could purchase over 6.5 Chinese yuan. In order for PPP to hold, the dollar should only have been able to purchase slightly over 3.5 yuan. This suggests that the yuan is under-valued by 46 percent relative to the dollar, indicating that the yuan would be expected to appreciate in the future. Conversely, the Swiss Franc was 31 percent over-valued relative to the dollar, indicating future mark depreciation.
A Big Mac Index Activity
[Note to teachers: Separate students in groups of 4 or 5 to complete this activity. Make sure they carefully follow the directions to the activity.]
Your assignment is to determine whether assorted currencies are under or overvalued against the dollar. Using the Big Mac prices reported in “the hamburger standard” table, fill in the missing blanks in this table. Use current currency rates from Currency Converter
Have students use the interactive graphic to examine 10 countries other than the U.S. to see how their Big Mac prices in dollars compares to the price of a Big Mac in the U.S. Complete the table by filling in the appropriate information in the blanks.
- What is the most over-valued of the above currencies?[Answers will depend on what the current exchange rates are and the countries chosen.]
- By how much does your Big Mac index indicate that this currency is over-valued?[This will also depend on current exchange rates and the countries chosen.]
- What is the most under-valued of the above currencies? [This will depend on the current exchange rate and the countries chosen.]
- By how much does your Big Mac index indicate that this currency is under-valued?[This will also depend on current exchange rates and the countries chosen.]
- Which currency is closest to PPP?[This will depend on current exchange rates and countries chosen.]
- (Optional) The interactive also lets you see how the currencies have fared on the Big Mac Index over time. The graph for most currencies seems to have gone down recently. What does this tell you about the strength of the U.S. dollar in comparison to other currencies?[Since prices are assumed unchanging, this implies than the U.S. dollar has appreciated (which is true).When the U.S. dollar appreciates, it makes Big Macs even cheaper in foreign countries, making other currencies more undervalued.]
- (Optional) Let’s take a look at the adjusted index. Why does the Big Mac Index tool also have a graphic that displays currencies when adjusted for GDP?[This is because GDP affects the ability of an average person to purchase a good. Countries have lower GDP are generally poorer, so the demand and the price of goods like the Big Mac are generally lower.]
- What are the limitations of PPP? [Some limitations include that for certain goods, variables other than exchange rate, such as local supply and demand determine the price of a good. Also, PPP assumes that prices are fixed, but this is not necessarily the case. Other answers can also be given such as GDP and local tastes.]
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!
Grades 6-8, 9-12
Grades Higher Education, 9-12