Purchasing Power Parity and the Big Mac Index

Purchasing Power Parity

• Law of One Price: This principle underlies Purchasing Power Parity (PPP).
• Arbitrage: Exploiting price differences for the same good in different markets to make a profit.

The Big Mac Index

• Origin: Invented by The Economist in 1986.
• Purpose: To serve as a lighthearted guide to assess whether currencies are at their "correct" level.
• Foundation: Based on the theory of Purchasing Power Parity (PPP).
  • PPP suggests that in the long run, exchange rates should move toward the rate that equalizes the prices of an identical basket of goods and services between two countries (in this case, a Big Mac).

How it Works

• PPP Implication: Exchange rates are determined by the value of goods that currencies can purchase.
• Price Differences: Differences in local prices (Big Macs) can indicate what the exchange rate should be.
• Valuation: The index estimates how much a currency is undervalued or overvalued relative to another.

Big Mac Exchange Rate Example

• Big Mac Price: $5 in the US, 20 yuan in China.
• Implied Exchange Rate: 1:4 (1 dollar for 4 yuan).
• Actual Exchange Rate: $1 = 6.4 yuan.
• Valuation: Yuan is 38% undervalued.

Limitations

• Not Precise: Burgernomics is not intended as a precise measure of currency misalignment.
• Purpose: It's a tool to make exchange-rate theory more understandable.

Global Standard

• Recognition: The Big Mac Index has become a global standard.
• Inclusion: It is included in economic textbooks and has been the subject of many academic studies.
• Gourmet Version: A gourmet version of the index is calculated for 55 countries plus the euro area.

Euro Area Example (January 2025)

• Big Mac Cost: €5.67 in the Euro area, US$5.79 in the United States.
• Implied Exchange Rate: \frac{5.67}{5.79} = 0.98
• Actual Exchange Rate: 0.95.
• Valuation: The euro is 2.8% overvalued.
  • \frac{0.98 - 0.95}{0.95} \approx 0.028 = 2.8\%

Japanese Yen Example (January 2025)

• Big Mac Cost: ¥480 in Japan, US$5.79 in the United States.
• Implied Exchange Rate: \frac{480}{5.79} \approx 82.90
• Actual Exchange Rate: 154.35.
• Valuation: The Japanese yen is 46.3% undervalued.
  • \frac{82.90 - 154.35}{154.35} \approx -0.463 = -46.3\%

Over/Under Valuation by Country (as of January 2025)

• Switzerland: 38.0% overvalued
• Argentina: 20.1% overvalued
• Uruguay: 19.3% overvalued
• Norway: 15.3% overvalued
• Euro area: 2.8% overvalued
• Costa Rica: 1.9% overvalued
• United States: Baseline (0%)
• Britain: -1.1% undervalued
• Sweden: -2.1% undervalued
• Denmark: -5.2% undervalued
• Canada: -6.2% undervalued
• Lebanon: -7.4% undervalued
• Turkey: -8.2% undervalued
• Poland: -10.0% undervalued
• Colombia: -10.6% undervalued
• Singapore: -10.7% undervalued
• Saudi Arabia: -12.5% undervalued
• United Arab Emirates: -15.4% undervalued
• Australia: -15.9% undervalued
• New Zealand: -17.5% undervalued
• Israel: -18.6% undervalued
• Mexico: -20.5% undervalued
• Czech Republic: -21.2% undervalued
• Chile: -21.5% undervalued
• Kuwait: -21.5% undervalued
• Peru: -21.8% undervalued
• Bahrain: -22.1% undervalued
• Nicaragua: -22.7% undervalued
• Venezuela: -23.1% undervalued
• Honduras: -28.8% undervalued
• Qatar: -28.8% undervalued
• Brazil: -30.5% undervalued
• Guatemala: -30.7% undervalued
• Thailand: -30.8% undervalued
• Oman: -31.4% undervalued
• South Korea: -33.6% undervalued
• Pakistan: -35.0% undervalued
• Azerbaijan: -36.6% undervalued
• Hungary: -37.0% undervalued
• Jordan: -39.1% undervalued
• Moldova: -39.2% undervalued
• China: -39.2% undervalued
• Romania: -40.8% undervalued
• Japan: -46.3% undervalued
• Hong Kong: -46.8% undervalued
• Vietnam: -47.7% undervalued
• Malaysia: -48.1% undervalued
• Philippines: -50.1% undervalued
• Ukraine: -50.7% undervalued
• South Africa: -52.0% undervalued
• Egypt: -53.6% undervalued
• India: -54.8% undervalued
• Indonesia: -56.2% undervalued
• Taiwan: -58.8% undervalued

Real Exchange Rates

• Further analysis and discussion on real exchange rates are expected to follow. This topic will delve deeper into factors affecting currency valuation beyond simple price comparisons.