The Big Mac Index

19 . 11 . 18

By Ignatius Wilson

The Big Mac Index is a way of expressing the strength of foreign currencies. Devised by The Economist magazine, the ubiquitous product of the ubiquitous fast food chain McDonalds should be identical in composition (sesame seed buns, cheese, lettuce, onion, pickle, sauce and beef patties) and in price wherever it is sold.

However, after accounting for currency conversion, the Big Mac Index shows that foreign currencies may be undervalued or overvalued compared to the US Dollar. This is what is called its PPP or purchasing-power parity.

To use an example we need to set out some assumptions: if today a Big Mac costs US$3 in America; the current AU:US exchange rate is 1.5; in Australia the Big Mac costs AU$4.50. The ratio of 4.5:3 equals 1.5 so we say the AUD has equivalent purchasing power to the USD.

If an Australian Big Mac cost $5 the AUD would be considered overvalued and strong as you need more than the converted currency equivalent to buy the same good.

If the Australian Big Mac cost $2 the AUD would be considered undervalued and weak as you need less AUD to buy the equivalent good. In this case, if converting AU$2 back to USD, you wouldn’t have enough USD to buy the same good!

But why does this matter? Well, in the context of international trade and foreign exchange there is a need to understand the purchasing power of currencies. If the AUD is undervalued this index signals it should perform better against the USD in future as it approaches purchasing power parity.

This has consequences for import (goods will become cheaper), export (goods will become more expensive), primary producers like farmers (who may find it harder to sell their produce overseas) and financiers who deal in currencies and enact monetary policy through the central bank.

Currently Egypt has the most undervalued currency and Switzerland has the most overvalued. This suggests that being overvalued is a sign of a strong economy and broadly this holds true across the index. However, if we look at how this index is measured again we can see there are possible confounding factors such as taxes on fast food, sugar and fat or price of labour that influence it.

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