The Big Mac Index: making exchange-rate theory a little more “digestible”
I was reading an edition of the Farmbrook Free Press a few months ago and was especially interested in an article written about Singapore. The article stated that Singapore is the most expensive country in the world! I vacationed in Singapore in January of 2019 for two weeks and can confirm that the country is indeed expensive. However, I started to ponder, what does it mean to say that a country is expensive? For whom is it expensive? Local residents? Tourists? Is it less expensive for an individual visiting from a country with a “strong” currency? Naturally this thought process led me directly to one possible answer for all of my inane questions: The Big Mac Index!
What is this Big Mac Index you may wonder? Well I have plenty of time in quarantine on my hands so please allow me to explain in a way which hopefully everyone will understand.
The Big Mac Index was created in 1986 by The Economist, a global international magazine published on a weekly basis. The index is meant to be used as an informal and “digestible” way to measure purchasing power parity (PPP) between two currencies and compare it to actual global exchange rates. PPP is a measure of prices for an identical “basket of goods” in two different countries. In this case we use the Big Mac as the basket of goods, since the burger is exactly made in exactly the same way in every country. In plain English, we are going to use the price of the Big Mac in various countries to show two different things:
Simply to compare the price in each country to see how expensive it is and how far your dollar will go in each country as a tourist.
Not so simply, to show the PPP exchange rate in terms of a Big Mac in comparison to the actual exchange rate between two currencies and thereby highlight which currencies are over and under-valued, in this case compared to the USD.
Exhibit A below shows the price of the Big Mac in a few selected countries. Prices are listed in USD based on current global exchange rates. Switzerland as you can see is a very expensive country and has the most expensive Big Mac in the world at $6.71. I have travelled to Switzerland many times and can confirm it is indeed a very expensive country. When I was a university student in Germany I lived very close to the Swiss border (Basel) and in that time commonly referred to Switzerland as a prohibitively expensive country!
The price of the Big Mac in Singapore is $4.38. This is relatively expensive compared to the rest of the world but according to this index it does not place Singapore as the most expensive country in the world. I would like to point out however that there is no one absolute way to measure this topic and it is continuously debated among the world’s top economists.
The second thing measured by the Big Mac Index is how much a currency is over or under-valued compared to another, in this case again the USD is the baseline. The value can be used by economists as an indicator how exchange rates will move in the long run.
Let’s use Switzerland as an example to highlight this concept:
The price of a Big Mac in USD based on actual global exchange rates is $6.71. This is based on a global exchange rate of $0.97 per Swiss Franc.
The PPP exchange rate based on the Big Mac is roughly $1.20 per Swiss Franc. This is calculated by dividing the price of the US Big Mac of $5.67 into the price in USD in Switzerland of $6.81. $6.81/$5.67 = ~$1.20
This compares with an actual exchange rate of $0.97
Therefore according to the Big Mac Index the Swiss Franc is OVERVALUED by 18.4%. See Exhibit B.
I hope after reading this you will realize that the Big Mac is much more than just two all beef patties, special sauce, lettuce, cheese, pickles, and onions on a sesame seed bun!
Many thanks to Kai [Editor] and the Farmbrook Free Press for letting me contribute.