Tuesday, March 25, 2008

Big Mac Index

The Big Mac Index was introduced by The Economist in September 1986 as a humorous illustration and has been published by that paper annually since then.

One suggested method of predicting exchange rate movements is that the rate between two currencies should naturally adjust so that a sample basket of goods and services should cost the same in both currencies. In the Big Mac Index, the "basket" in question is considered to be a single Big Mac burger as sold by the McDonald's fast food restaurant chain. The Big Mac was chosen because it is available to a common specification in many countries around the world, with local McDonald's franchisees having significant responsibility for negotiating input prices. For these reasons, the index enables a comparison between many countries' currencies.

The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued.

How under Valued is Chinese Currency

Suppose the price of a Big Mac is $3.41 in the United States (as it was in July 2007) and 11 Yuan in in China (as it was in July 2007); thus, the PPP rate is $3.41/Tuan 11 = .31 dollar/yuan. In July 2007, $1 bought 7.0625 Yuan, then the Yuan is under-valued by $0.1684 ($0.31 - $0.1416.), or 54.3% ($0.1684/$0.31) in comparison with the price of the Big Mac in both countries.
Another example is the Hong Kong Dollar. The price of a Big Mac in the US was $3.41 in July 2007 and HK$12.00 in Hong Kong at the same time; thus, the PPP rate is $3.41/HK$12 = .284 dollar/HK$. In July 2007, $1 bought HK$ 7.78, then the HK$ is under-valued by $0.155 ($0.284 - $0.129.), or 54.6% ($0.155/$0.284) in comparison with the price of the Big Mac.

Now lets compare this to the UK a country that does not manipulate it's currency with the US. The price of a Big Mac in the UK was £ 1.99. So the PPP rate is £ 1.99/$3.41= .584. Once again based on numbers from July of 07 the £ .5048 bought $1, so the dollar is under valued by £.079 or 13.5%. 

The Big Mac Index has limitations in its estimates of the PPP. Eating at international fast-food chain restaurants such as McDonald's is relatively expensive in comparison to eating at a local restaurant, and the demand for Big Macs is not as large in countries other countries as it is in the United States. Social status of eating at fast food restaurants like (eating at KFC and to some extent McDonald's is like going to a slightly upscale chain restaurant in the United States a college student could take a girl on a nice date to KFC or McDonald's, local taxes, levels of competition, and import duties on selected items may not be representative of the country's economy as a whole. This said there seems to be a drastic difference in the PPP between China and the US.