- Economists have a keen eye for burger prices, thanks to the Big Mac Index
- The index suggests that euro-dollar parity could be justified
Late last month, McDonald’s announced that it was increasing the price of a cheeseburger for the first time in 14 years. It has risen by 20 per cent, from 99p to £1.19, as the soaring cost of food and energy leaves even the restaurant giant "feeling the impact of rising inflation". The move made the headlines, proving a particularly hard-to-stomach example of the cost of living squeeze. But it may have garnered attention for another reason: commentators are particularly attuned to the cost of a McDonald's burger. And this is all thanks to the Big Mac Index.
The Big Mac Index was developed by The Economist magazine in 1986 as a "lighthearted guide to whether currencies are at their 'correct' level". It makes exchange rate theory so digestible that you will find it referenced in economics textbooks, academic studies and even IMF reports today.
The Big Mac Index is based on the theory of purchasing power parity (PPP). This theory of exchange rate determination sets out that, in the long run, exchange rates should move towards a rate that equalises the price of a basket of identical goods and services in two countries. ‘Official’ PPP measures are calculated by the International Comparisons Programme, which looks at a basket of 1,000 goods across 176 countries. But the Big Mac Index discards the basket of goods, and uses a burger instead: a difference in the price of a Big Mac between two countries indicates that one currency is overvalued relative to the other.
As an approximation, it's not as silly as it sounds. A basket of groceries in the UK and US could differ drastically, but a Big Mac is (almost) identical throughout the world. The Economist has even developed a gross domestic produc (GDP)-adjusted index to address the fact that you would expect average burger prices to be cheaper in poor countries than in rich ones, thanks to lower labour costs.
The Big Mac Index currently provides an interesting perspective on euro-dollar parity. A Big Mac costs $5.15 in the US, and €4.65 in the euro area, giving an implied EUR/USD exchange rate of 1.11. At the time of writing, the actual exchange rate was 1.02, which implies that the US dollar is 8.1 per cent overvalued against the euro. The situation is even more extreme for sterling. As the chart below shows, the Big Mac-implied exchange rate suggests that the pound is 13.8 per cent undervalued against the dollar, and 6.8 per cent against the euro.
Does this mean that a correction is likely? It's not a given. When adjusted for GDP, the Big Mac Index suggests that the weak euro may actually be justified. The GDP-adjusted Big Mac Index takes into account differences in the price of inputs, and so reflects the fact that some countries are more ‘expensive’ than others. Once we take higher US input costs into account, the euro looks to be 4.2 per cent overvalued, suggesting that it ‘should’ be trading below parity. The situation for sterling is more puzzling. Even adjusted for GDP, the Big Mac Index suggests that the pound is 6.1 per cent undervalued against the dollar, and 9.9 per cent against the euro.
How can we explain sterling’s weakness? It is worth noting that PPP only really offers an insight into long-run exchange rate movements. In the shorter term, economists theorise that a whole array of factors can influence exchange rates. These include interest rates, the money supply, demand for imports and exports, perceptions of risk, news and speculation. This means that while PPP exchange rates tend to move slowly and smoothly, market rates can be much more volatile.
We have seen a case in point this month. In the hours following last week’s monetary policy committee meeting, sterling dipped over 0.5 per cent against the dollar, as markets were rattled by gloomy economic projections. This had everything to do with short-term drivers, and owed considerably less to the price of Big Macs converging.
