Saturday, February 21, 2009

The Big Mac Index

Big Mac was created in 1968 by a McDonald’s franchisee in Pittsburgh, Pennsylvania.
Millions of viewers was asked the following question in a 1970s TV commercial.


This sandwich is currently sold at over 25,000 McDonald’s restaurants in 120 countries around the world. Because of its popularity, the Big Mac allows economists to make comparisons of exchange rates and relative prices in countries around the globe. This comparison is by using an indicator called "Big Mac Index".

The Big Mac Index was introduced in The Economist in September 1986 by Pam Woodall as a semi-humorous illustration and has been published by that paper annually since then. The index also gave rise to the word burgernomics.

The Big Mac Index is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our "basket" is a McDonald's Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under or overvalued.

For example, using figures in July 2008:
* The exchange rate in July 08 between US and UK is 2:1
* The price of a Big Mac was $3.57 in the US and £2.29 in the UK
* This means that the same Big Mac actually cost $4.57 in UK compared to $3.57 in US.
* The implied purchasing power parity was 1.56, that is the local price in Britain divided by the price in the United States and this compares with an actual exchange rate of $2.00 to £1 at the time.
* In conclusion, the pound was overvalued against the dollar by 28%.

This index is no way a precise forecasting tool of currency value. A Big Mac's price reflects more than just the cost of bread and meat and vegetables. They can also be distorted by differences in the cost of non-tradable goods and services, such as rents and labour. Nevertheless this index is still published and followed by some people.

My last check
Singapore Big Mac cost $3.95, US Big Mac cost $3.54
Exchange Rate is US$1 : S$1.51
Our Singapore Big Mac actually cost only US$2.61 in Singapore
Hence, are our currency undervalued by 26.3% compared to the US currency???

It may sounds very unprofessional and silly to use the Big Mac to forecast currency value but over the years, it had indeed provided some indication as to where the world's major currencies may be going.

1 comment:

Anonymous said...

As a quick way or at a glance comparison of the currency but this comparison doesn't take into account many factors, like wages, cost of the bread, rent and so forth. It is good at a glance.