Introduction:

The Big Mac Index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their correct level. In other words, The Economist's Big Mac index is based on
the theory of purchasing-power parity: that, in the long run, exchange rates should adjust to equal the price of a basket of goods and services in different countries. For example, the average price of a Big

Mac in America in July 2013 was $4.56; in China it was only $2.61 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 43% at that time. 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 any two countries. This adjusted index addresses the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. The adjusted index uses the line of best fit between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country, given its income per person, and its actual price gives a supersized measure of currency under- and over-valuation. The big mac theory also known as Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible. Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies.

Purchasing power parity (PPP) states that the price of a good in one country is equal
to its price in another country after adjusting for the exchange rate between the two countries. As a light-hearted annual test of PPP, The Economist has tracked the price of McDonald's Big Mac burger in many countries since 1986. This experiment - known as the Big Mac PPP - and similar tests have been underway for decades. Purchase power parity (PPP) is the theory that currencies adjust according to changes in their purchasing power. For example, With the Big Mac PPP, purchasing power is reflected by the price of a McDonald's Big Mac in a particular country. The measure gives an impression of how overvalued or undervalued a currency is.

To illustrate PPP, let's assume the U.S. dollar/Mexican peso exchange rate is 1/15 pesos. If the price of a Big Mac in the U.S. is $3, the price of a Big Mac in Mexico would be 45 pesos assuming the countries have purchasing power parity.

Purchasing power parity is the price of a Big Mac in nation X divided by the price of a Big Mac in U.S. dollars. Essentially, the exchange rate is the percentage of under- or overvaluation of a currency. A lower price means the first currency is undervalued compared to the second currency, while a higher price means the second currency is overvalued in percentage terms against the dollar. The concept behind this is that prices will eventually equalize over time. While this simple formula may serve as a theoretical guide to determine under- and overvalued currencies, practicality says many limitations exist in the short and long term for measuring evaluations and achieving successful trades. If, however, the price of a Big Mac in Mexico is 60 pesos, Mexican fast-food shop owners could buy Big Macs in the U.S. for $3, at a cost of 45 pesos, and sell each in Mexico for 60 pesos, making a 15-peso risk-free gain. (Although this is unlikely with hamburgers specifically, the concept applies to other goods as well.) To exploit this arbitrage, the demand for U.S. Big Macs would drive the U.S. Big Mac price up to $4, at which point the Mexican fast-food shop owners would have no risk-free gain. This is because it would cost them 60 pesos to buy U.S. Big Macs, which is the same price as in Mexico thus restoring PPP. PPP also means there will be parity among prices for the same good in all countries (the law of one price).

Short-Term Vs. Long-Term Parity

Empirical evidence has shown that for many goods and baskets of goods, PPP is not observed in the short term, and there is uncertainty over whether it applies in the long term. Pakko & Pollard cite several confounding factors as to why PPP theory does not line up with reality in their paper "Burgernomics" (2003). The reasons for this differentiation include:

Transport Costs: Goods that are not available locally will need to be imported, resulting in transport costs. Imported goods will thus sell at a relatively higher price than the same goods available from local sources.

Taxes: When government sales taxes, such as value-added tax (VAT), are high in one country relative to another, this means goods will sell at a relatively higher price in the high-tax country. Government Intervention: Import tariffs add to the price of imported goods. Where these are used to restrict supply, demand rises, causing price of the goods to rise as well. In countries where the same good is unrestricted and abundant, its price will be lower. Governments that restrict exports will see a good's price rise in importing countries facing a shortage, and fall in exporting countries where its supply is increasing. (To learn how importing and exporting influences currency value, be sure to read Current Account Deficits.)

Non-Traded Services: The Big Mac's price is composed of input costs that are not traded. Therefore, those costs are unlikely to be at parity internationally. These costs can include the cost of premises, the cost of services such as insurance and heating and especially the cost of labor. According to PPP, in countries where non-traded service costs are relatively high, goods will be relatively expensive, causing such countries' currencies to be overvalued relative to currencies in countries with low costs of non-traded services. Market Competition: Goods might be deliberately priced higher in a country because the company has a competitive advantage over other sellers, either because it has a monopoly or is part of a cartel of companies that manipulate prices. The company's sought-after brand might allow it to sell at a premium price as well. Conversely, it might take years of offering goods at a reduced price in order to establish a brand and add a premium, especially if there are cultural or political hurdles to overcome.

Inflation: The rate at which the price of goods (or baskets of goods) is changing in countries, the inflation rate, can indicate the value of those countries' currencies. Such relative PPP overcomes the need for goods to be the same when testing absolute PPP discussed above.

Conclusion:
THE Big Mac index is 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 global exchange rates should eventually adjust to make the price of identical baskets of tradable goods the same in each country.

PPP dictates that the price of an item in one currency should be the same price in any other currency, based on the currency pair's exchange rate at that time. This relationship often does not hold in reality because of several confounding factors. However, over a period of years, when prices are adjusted for inflation, relative PPP has been seen to hold for some currencies. The idea behind the Big Mac Index was to measure the percentage of overvaluation and undervaluation between two currencies in each nation by comparing prices of a Big Mac hamburger, using the U.S. dollar through the Federal Reserve's trade-weighted average as its base. This is effective because Big Macs are sold in almost 120 nations. Since the Big Mac became the standard consumer good common to all nations, devising a method for determining overvaluation and undervaluation of currency pairs would be based on the formula of purchasing power parity.