By Cindy Ivanac-Lillig
The Economist magazine annually publishes the so-called “Big Mac Index.” The index compares what a Big Mac costs here in the U.S. to what it costs in different countries. It is a tangible illustration of the Purchasing Power Parity (PPP).
The basic theory behind the index and behind the economic concept of PPP is to compare the price of a basket of common goods after taking into account the differences in the cost of living and inflation. The difficulty of doing this, of course, is choosing a basket that would be of similar quality and desirability that could be compared across many countries. The Economist chose the Big Mac as a proxy for the basket. The Big Mac is sold in over 100 countries and is similar in terms of quality. In fact Wikipedia even shows some fun images of Big Macs from different parts of the world –and they do look remarkably similar. Check out the pictures!
The Big Mac Index is a great way to have beginner students think about exchange rates in a tangible way and for more advanced students to look at long-term exchange rate parities and currency valuations.
The PPP rates in this table suggest what the exchange rate should trend towards in the long-run to have the Big Mac cost the same in real terms as in the U.S. If the actual exchange rate is higher than the PPP rate then the currency is undervalued relative to the U.S. dollar and vice-versa. (For a more advanced analysis, check out the Dismal Scientist blog on the Big Mac Index–click here).
Check out the index and let me know what you think. How about those poor Norwegians!
Have any of you ever used this index either professionally in a presentation or in the classroom?