As we are entering a new age of Mass Intelligence (as described by The Economist), ignorance is severely punished and curiosity no longer kills the cat. The following statement ranks high in our daily lives: Curiosity is knowledge and knowledge is power. So, in order to become powerful, one must first possess a certain degree of curiosity and seek out new knowledge that could be turned into power.
For starters, economics is a subject that should be understood by everybody, as it studies the world around us and instructs on how to make use of valuable and scarce resources to meet our needs. The Economist is actively pursuing the goal of teaching the masses with its Big Mac Index ever since it was developed, back in 1986. It might sound like a joke, but it is perfectly functional and reliable!
What is it exactly? The price of a Big Mac acts as a benchmark for measuring PPP across nations.
The price of a Big Mac acts as a benchmark for measuring PPP across nations.
The Big Mac Index is a light-hearted and engaging way of measuring Purchasing Power Parity (from here on referred to as PPP). The price of a Big Mac acts as a benchmark for measuring PPP across nations. The idea is that any change in exchange rates in different currencies affects the price for a basket of goods, in this case, a Big Mac.
The theory of PPP states that the price for an identical basket of goods should be the same across countries. The basket of goods is substituted simply by the famous Big Mac, which is assumed to be the same around the globe (maybe with a few exceptions). Comparing prices for the hamburger in various countries, one can see which currencies are over or under evaluated.
Since 2006, the index has been published twice per year, in January and in July, with the latest version published on January 22, 2015.
Bloomberg has introduced in 2009 its own variation of the Big Mac index, called the Billy Index. It is based on the popular Billy Bookshelf sold by Ikea. However, the ‘Billy’ has not really taken off, and economists still refer to the Big Mac as the go-to index for a more ‘digestible’ measure of exchange rate theory, as The Economist likes to call it.
A quick example
Taking the values from the latest index, the average price for a Big Mac in the United States is 4.79 dollars and in Russia is 89 rubles. The resulting purchasing power parity would then be:
89 rubles / 4.79 dollars = 18.58. This is an implied exchange rate, meaning 18.58 rubles for every dollar.
However, the actual exchange rate was, on that date, 65.23 rubles for 1 dollar. This means that the price of a Big Mac in Russia is 1.36 dollars. Consequently, the price for an identical basket of goods – a hamburger – is not actually the same. In fact, the Russian hamburger is undervalued by 71.5% ( (18.58 – 65.23)/65.23).
As can be seen from the latest index published, most currencies are undervalued as compared to the dollar. Only a few countries, with Switzerland on top, have overvalued currencies.
Currently, the most overvalued currency is the Swiss Franc, with 57.5% over the US Dollar. And at the other end of the spectrum is the Ukrainian Hryvnia, undervalued by 74.9%.
The index is an undoubtedly entertaining, yet simplistic measure. It does not control for taxes, the cost of labor or the cost for the ingredients, all of which vary across nations. This being said, the Big Mac Index was never intended as a precise measurement of currency misalignment. It simply gives a rough, general idea of how prices vary in different countries and it’s a straightforward way of understanding exchange rates and purchasing power parity.