The Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries.
Here is something that I put together using the the Big Mac index from The Economist website. Students have to complete the table below and answer the questions that follow. It makes for a good discussion of PPP amongst countries
The Big Mac Index – January 2018
* Estimated figures
1. Complete the table above. In which country was their actual exchange rate on January 2018 closest to their Big Mac exchange rate?
2. Which country’s currency is suggested by your calculations above as being
a) the most undervalued against the dollar, and
b) the most overvalued against the dollar?
3. What factors could have an influence on exchange rate values on a given date as shown in the table above?
4. Differences in the prices of hamburgers could exist in the real world for a number of reasons. Suggest one reason relating to a) supply and b) demand which could lead to apparent deviations from equilibrium exchange rate values.
Here is a useful video clip on the Big Mac index – also referred to as Burgernomics. Developed by “The Economist” magazine it is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad – the video explains PPP and shows how undervalued / overvalued an exchange rate is relative to a Big Mac exchange rate.
For example, the average price of a Big Mac in America in January 2015 was $4.79; in China it was only $2.77 at market exchange rates. So the “raw” Big Mac index says that the yuan was undervalued by 42% at that time. However, the index does not consider the different levels of income, as most of the burger’s cost depends on local inputs which vary considerably between countries. See the clip below
Below is graph that shows the GDP per person and Purchasing Power Parity (PPP). During the 1970’s New Zealand was well above the OECD average but has had a downward movement since 1982. Australian continues to hold its own.
Our material well-being
• The standard of living is simply a measure of the economic or material welfare of the inhabitants of a country, a region or a local area.
• The baseline measure is real national output per head of population.
• Real income per capita is an inaccurate and insufficient indicator of living standards
Per Capita National Incomes
National income data can be used to make cross-country comparisons. This requires:
1. Converting GDP data into a common currency (normally the dollar or the Euro)
2. Making an adjustment to reflect differences in the average cost of goods and services in each country to produce data expressed at a ‘purchasing power parity’ standard
Data on per capita income based on a country’s total personal income are rarely available. Thus, the Gross domestic product (GDP) is more commonly used. However, the total personal income is generally lower than the gross domestic income.
A list of the top ten countries, and the lowest-ranking country, by GDP per capita (in terms of purchasing power parity – PPP – and nominal values) for the year 2010
Problems of accuracy:
Officially data on a nation’s GDP tends to understate the true growth of real national income per capita over time e.g. due to the expansion of the shadow economy and the value of unpaid work done by millions of volunteers and people caring for their family members. There may also be errors in calculating the cost of living
The scale of the informal “shadow economy” varies widely across countries at different stages of development. According to the IMF, in developing countries it may be as high as 40% of GDP; in transition countries of central and Eastern Europe it may be up to 30% of GDP and in the leading industrialised countries of the OECD, the shadow economy may be in the region of 15% of GDP
Having arrived in Spain (Mallorca) last night just before the euro final I could not post something about football – the Spanish know how to celebrate. Spain showed their class and are an exceptional team to have won three major tournaments in the last four years. Some have likened them to the Brazil team of 1970.
In keeping with Spanish football, I came across Simon Kuper, co-author of Soccernomics, on the eZonomics website by ING. One particular part of the site focuses on soccer – Cup-o-nomics – in which current issues in the sport are related to economics. With the Euro 2012 Championship on he has written several articles about players. managers etc.
In July 2007, the Spanish striker Fernando Torres moved from Athletico Madrid to Liverpool. Torres commanded a salary of £90,000 (NZ$175,500) a week at Liverpool, equivalent to £4.6m (NZ$9.1m) a year. Interestingly enough this was a salary cut as at Athletico he was on an annual salary of €8 million (about NZ$10.5 million). However within a year of signing for Liverpool the purchasing power of his income decreased for the following reasons:
1. The pound depreciated against the euro (hard to believe now) by around 20%. Most foreign players tend to send home a lot of their salary and therefore Torres needed to use more pounds to buy euros.
2. After 2008 and the financial crisis the UK experienced over 5% inflation which again would have lessened the purchasing poser of his income. Most soccer players are on a given salary for the duration of their contract and therefore don’t have their income indexed to the CPI or cost of living.
Even all this said, Fernando Torres is probably not too worried about exchange rate fluctuations or inflation rates when you look at his salary and the season he has just had with Chelsea and Spain.
Last week in Washington DC the annual meetings of the World Bank and IMF took place. High on the agenda was the appropriate level of exchange rates at which countries should trade in the globalised environment. China has been deliberately keeping its exchange rate low in order to maintain a competitive advantage in its exports. Normally when countries achieve a balance-of-payments surplus their exchange rate appreciates (as more of the their currency is demanded) and thereby encourages imports and enable other countries (western economies) to produce and export more. A way out of this currency protection is if these surplus countries stimulated domestic demand so that export revenue would be less significant in the make up of their GDP. The Chinese delegation in Washington are not against rebalancing their currency but they suggest that this takes time. Time which the west cannot afford.
To give you an indication of how undervalued the Yuan (Chinese currency) is The Economist produced a recent Big Mac index chart – see below.
In China a McDonald’s Big Mac costs just 14.5 yuan on average in Beijing and Shenzhen, the equivalent of $2.18 at market exchange rates. In America the same burger averages $3.71. That makes China’s yuan one of the most undervalued currencies in our Big Mac index, which is based on the idea of purchasing-power parity. This says that a currency’s price should reflect the amount of goods and services it can buy. Since 14.5 yuan can buy as much burger as $3.71, a yuan should be worth $0.26 on the foreign-exchange market. At just $0.15, it is undervalued by about 40%. The tensions caused by currency misalignments prompted Brazil’s finance minister to complain last month that his country was a potential casualty of a “currency war”. The Swiss, who avoid most wars, are in the thick of this one. Their franc is the most expensive currency on our list.