Purchasing Power Parity & the Big Mac Index

Purchasing Power Parity & the Big Mac Index
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  • 0:05 What Is the Big Mac Index?
  • 0:54 What Is Purchasing…
  • 3:16 Using the Big Mac Index
  • 5:05 Lesson Summary
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Lesson Transcript
Instructor: Beth Loy

Dr. Loy has a Ph.D. in Resource Economics; master's degrees in economics, human resources, and safety; and has taught masters and doctorate level courses in statistics, research methods, economics, and management.

In this lesson, we explore the Big Mac index, which analyzes whether currencies are at their correct levels using the theory of purchasing-power parity. We discuss the index and look at examples of how to read and use it.

What Is the Big Mac index?

Do you ever crave a Big Mac? If you buy a Big Mac from a McDonald's in New York City, will it cost the same as if you bought it in Toronto, Canada? Given the differences between the Canadian and U.S. dollars, do we get our Big Macs for the same price? We can actually figure this out using the Big Mac index.

The Big Mac index was made popular by Pam Woodall, who published it in The Economist magazine in 1986. Ever since then, the magazine has shared a yearly version of Woodall's burgernomics. Woodall caught everyone's attention by using humor to explain the economic concept of purchasing-power parity (PPP). Her burgernomics theory, the Big Mac index, discusses whether the PPP between two currencies means we can purchase a Big Mac for the same cost in different countries.

What Is Purchasing Power Parity?

The purchasing-power parity, or PPP, is when the purchasing power of two different countries' currencies is the same and causes the exchange rate between them to be in equilibrium, meaning static. And remember that the exchange rate is the rate that one currency can be traded for another. For example, imagine the euro and the United States dollar are carrying the same purchasing power. This means that their exchange rate remains unchanged. Burgernomics will tell us whether the rate is overinflated, underinflated, or right on the mark. An overinflated currency is one where the price is greater than its innate value. On the other hand, an underinflated currency is one where the price is less than its innate value.

The Big Mac index is used to predict future movements in the exchange rate. The theory is that the exchange rate should automatically adjust over time so that a Big Mac will cost the same in different countries. So if the Canadian dollar is overinflated at one point in time, it will eventually fall to where a Big Mac will cost the same as it does in the United States. This is the point where the exchange rates from Canada and the United States are equalized. Let's see how this works by first looking at the formula for PPP and then working through an example.

PPP = P1 / P2

P1 is the cost of good x in currency 1, and P2 is the cost of good x in currency 2.

If a Coke costs US$1 in the United States and C$2 in Canada, the PPP for CDN / USD would be 2 / 1, or 2 CDN / 1 USD (Canadian Dollars / U.S. Dollars). This would be called our Big Mac index valuation for CDN / USD.

A Coke that costs C$2 in Toronto should cost US$1 in New York City when the exchange rate is 2 CDN / USD. When this happens, the cost of a Coke is the same in both countries. Each Coke costs US$1. If the Canadian currency is overvalued, the price of a Coke will be inflated in Canada, and it will then be cheaper to buy a Coke in New York City. Let's look further into the Big Mac index and see how we can use it to make predictions related to long-run exchange rates.

Using the Big Mac index

A Big Mac is made of two hamburger patties with cheese, lettuce, tomatoes, and spicy sauce. And we can't forget that it's on a sesame seed bun! Although there are exceptions, we will work off of the assumption that the Big Mac is almost always the same sandwich wherever you buy it. You can buy it in Australia or China, for example, and it will be virtually identical.

If a Big Mac is US$5 in New York City and C$3.75 in Toronto, we take US$5 / C$3.75 = $1.33 USD/CDN to find the PPP.

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