The Big Mac Index

Dr. Katherine Sauer A Citizens Guide to Economics ECO 1040

Fun with Exchange Rates:

The Economists Big Mac Index

The index is a lighthearted attempt to gauge how far currencies are from their fair market value. It is based on the theory of purchasing power parity (PPP). -says that in the long run exchange rates should move to equalize the price of an identical basket of goods between two countries

Our basket consists of a single item, a Big Mac hamburger, produced in nearly 120 countries. The fair-value benchmark is the exchange rate that leaves burgers costing the same in America as elsewhere.

The price youd see on the menu board. The price converted into US dollars. The exchange rate that would make the foreign price equal to the US price.

Big Mac Prices actual in local price in implied PPP exchange rate currency US$ of the US$ per US$

over/under valued vs the US$

US $3.73 $3.73 . . . Czech 67.6kr $3.43 18.1 19.7 -8 Rep_____________________________________________________ To calculate the price in US$: Multiply the local price by the actual exchange rate. 67.6kr x 1$ 19.7kr = $3.43

If you bought a Big Mac in the Czech Republic, it would cost you 67.6kr . Which means it really costs you $3.43. - It is more expensive to buy a Big Mac in the US than Czech.

Big Mac Prices actual in local price in implied PPP exchange rate currency US$ of the US$ per US$

over/under valued vs the US$

US $3.73 $3.73 . . . Czech 67.6kr $3.43 18.1 19.7 -8 Rep_____________________________________________________ To calculate the implied PPP of the US$: Divide the local price in the foreign country by the local price in the US PPP rate = 67.6 / 3.73 = 18.1

Big Mac Prices actual in local price in implied PPP exchange rate currency US$ of the US$ per US$

over/under valued vs the US$

US $3.73 $3.73 . . . Czech 67.6kr $3.43 18.1 19.7 -8 Rep_____________________________________________________ Compare the PPP rate to the actual exchange rate to see if the currency is over or undervalued versus the US$. To calculate how much the koruna is under or overvalued by: (PPPrate actual exchange rate) / actual exchange rate x 100 (18.1 19.7) / 19.7 x 100 = -8.12

Because the koruna is undervalued vs the dollar, we expect the koruna to appreciate vs the dollar in the future.

Big Mac Prices actual in local price in implied PPP exchange rate currency US$ of the US$ per US$

over/under valued vs the US$

US $3.73 $3.73 . . . C.Rica 2,000c $3.83 536 522 3 ________________________________________________________ Calculate the price in US$:

2,000c x

1$ 522c

$3.83

If you bought a Big Mac in Costa Rica, it would cost you 2000 colones. Which means it really costs you $3.83. -It is less expensive to buy a Big Mac in the US than Costa Rica.

Big Mac Prices actual in local price in implied PPP exchange rate currency US$ of the US$ per US$

over/under valued vs the US$

US $3.73 $3.73 . . . C.Rica 2,000c $3.83 536 522 3 ________________________________________________________ Calculate the implied PPP of the US$: Divide the local price in the foreign country by the local price in the US PPP rate = 2000 / 3.73 = 536.19

Big Mac Prices actual in local price in implied PPP exchange rate currency US$ of the US$ per US$

over/under valued vs the US$

US $3.73 $3.73 . . . C.Rica 2,000c $3.83 536 522 3 _____________________________________________________ Check to see if the currency is over or undervalued versus the US$. To calculate how much the colone is over or undervalued by: (PPPrate actual exchange rate) / actual exchange rate x 100 (536 522 / 522 x 100 = 2.68

Because the colone is overvalued vs the dollar, we expect the colone to depreciate vs the dollar in the future.

Given the price in local currency and the actual exchange rate, you can calculate - price in dollars - implied PPP rate - over/under valuation