Simple ”quick and dirty” economic modeling can give powerful insight
The Economist’s Big Mac Index has traditionally been thought of as an interesting yet dubious proxy for currency valuations and purchasing power.
Mcdonald’s has a vast array of branches worldwide. Next to the Cola companies Mcdonald’s has, what might be, the most widely distributed common product worldwide: The Big Mac. The Economist thus ingeniously constructed the Big Mac Index which is a simplified model of purchasing power and currency value.
The most beautiful economic models are very simple yet generate very interesting insights. I believe the Big Mac Index is one of those. The Big Mac Index is often referred to in economic and business papers. Mostly with a light humor but always seeking buried truths.
Purchasing power parity, also known as PPP is a broadly used economic concept. According to purchasing power parity currency rates, in the long run, will move towards en equilibrium in which the cost of goods and services will be equal in different countries (adjusting for shipping costs, income taxes etc.).
Purchasing power parity is most commonly used in comparing living standards in different countries. While salaries in New York may be higher so are prices of common goods such as homes. As such, in terms of purchasing power parity one does not necessarily have a higher living standard simply because one earns more.
The following map, by Wikipedia, illustrates the purchasing power parity of the gross domestic product for the countries of the world (2003). The US is the base country, so it is 100. The highest index value, for Bermuda, is 154, so the same goods are 54% more expensive in Bermuda than in the United States:
Which currencies are overvalued and which are undervalued according to the Big Mac Index?
According to The Economist more currencies seem “out of whack” this July compared to last year. The Big Mac Index shows only a handful of currencies are close to their Big Mac purchasing power parity. According to the Big Mac Index:
- The Australian dollar is within 10% of its fair value
- The Euro is overvalued by 50%
- Other European currencies such as the British Pound, Swedish Krona, Swiess Franc and even the Canadian dollar are all overvalued compared to their Big Mac purchase power parity.
- Only the Japanese Yen is undervalued by 27%.
For the complete data and worldwide prices of Big Macs and their implied Dollar value please visit The Economist.
These results are far from surprising. The US Dollar has weakened greatly these past couple of years and an overshooting downwards is very probable. The following graph shows the US Dollar vs. the Euro:
While almost any other major currency strengthened significantly vs. the US dollar low interest rates in Japan are giving the Yen a hard time.
I believe The Big Mac Index reflects the major macro trends in world currencies, even if a bit roughly. It is a lovely example of a very simple extrapolation with good economic common sense at its basis.