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The Big Mac index by The Economist

The Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their "correct" level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries. The Economist's basket contains only a Big Mac, and relies on the efforts of McDonald’s to produce identical products from the same ingredients everywhere (or almost everywhere: for India we use the Maharaja Mac, which contains chicken rather than beef). For example, the average price of a Big Mac in America at the start of 2013 was $4.37; in China it was only $2.57 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 41% at that time.

Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible. Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. For those who take their fast food more seriously, The Economist has also calculated a gourmet version of the index.

The Big Mac index suggests that currencies are particularly overvalued in Norway, Switzerland and Brazil (see chart). The euro is now around 12% too expensive relative to the dollar, according to the gauge; in the summer of 2012 it was close to fair value. Currencies in much of the emerging world, including Russia, China, and India, are too cheap relative to the dollar on our gauge. Critics of burgernomics say that you would expect average prices to be cheaper in poor countries than in rich ones because labor costs are lower: PPP signals where exchange rates should head over the long run, as a country like China gets richer, not where prices should be right now. Even so, the perennially undervalued yuan has scarcely moved towards the Big Mac measure of fair value.

The adjusted index addresses the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labor costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. The adjusted index uses the "line of best fit" between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country, given its income per person, and its actual price gives a supersized measure of currency under- and over-valuation.

For a full and updated coverage of the Big Mac index visit

http://www.economist.com/topics/big-mac-index

and enjoy the interactive features of the site.

 2013-02-17 

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