- Economists have a close eye on hamburger prices, thanks to the Big Mac Index
- The index suggests that the euro-dollar parity could be justified
Late last month, McDonald’s announced it was raising the price of a cheeseburger for the first time in 14 years. It rose 20% from 99p to £1.19 as soaring food and energy prices let even the restaurant giant ‘feel the impact of rising inflation’. The move grabbed headlines, proving a particularly hard-to-digest example of cost-of-living squeezing. But it may have caught the eye for another reason: Reviewers pay particular attention to the price of a McDonald’s burger. And it’s all thanks to the Big Mac Index.
The Big Mac Index was developed by The Economist magazine in 1986 as a “lightweight guide to whether currencies are at their ‘correct’ level”. This makes exchange rate theory so digestible that today you will find it referenced in economics textbooks, academic studies, and even IMF reports.
The Big Mac index is based on the theory of purchasing power parity (PPP). This theory of exchange rate determination states that in the long term, exchange rates should move towards a rate that equalizes the price of a basket of identical goods and services in two countries. The “official” PPP measures are calculated by the International Comparisons Program, which examines a basket of 1,000 goods in 176 countries. But the Big Mac index rejects the basket of goods and uses a hamburger instead: a difference in price of a Big Mac between two countries indicates that one currency is overvalued against the other.
As an approximation, it’s not as silly as it sounds. A grocery basket in the UK and the US may differ drastically, but a Big Mac is (almost) the same all over the world. The Economist even developed an index adjusted for gross domestic product (GDP) to account for the fact that average hamburger prices would be expected to be cheaper in poor countries than in rich ones, thanks to costs weaker workforce.
The Big Mac index currently offers an interesting perspective on the euro-dollar parity. A Big Mac costs $5.15 in the US and €4.65 in the Eurozone, giving an implied EUR/USD exchange rate of 1.11. At the time of writing this report, the real exchange rate was 1.02, which means that the US dollar is 8.1% overvalued against the euro. The situation is even more extreme for the pound sterling. As shown in the chart below, the Big Mac’s implied exchange rate suggests that the pound is undervalued by 13.8% against the dollar and 6.8% against the euro.
Does this mean that a correction is likely? It is not given. When adjusted for GDP, the Big Mac index suggests that the euro’s weakness may in fact be justified. The GDP-adjusted Big Mac index takes into account differences in input prices and thus reflects the fact that some countries are more “expensive” than others. Once we factor in rising input costs in the US, the Euro appears to be overvalued by 4.2%, suggesting that it “should” be trading below parity. The situation for the pound sterling is more disconcerting. Even adjusted for GDP, the Big Mac index suggests that the pound is undervalued by 6.1% against the dollar and 9.9% against the euro.
How to explain the weakness of the pound sterling? It should be noted that PPP really only offers a snapshot of long-term exchange rate movements. In the shorter term, economists hypothesize that a whole series of factors can influence exchange rates. These include interest rates, money supply, import and export demand, risk perceptions, news and speculation. This means that while PPP exchange rates tend to move slowly and smoothly, market rates can be much more volatile.
We saw an example of this this month. In the hours after last week’s monetary policy committee meeting, the pound fell more than 0.5% against the dollar as markets rocked by gloomy economic projections. It had everything to do with short-term movers and owed much less to the price of Big Mac convergence.