What Is the Big Mac PPP?
The Big Mac PPP (purchasing power parity) is an annual survey started in 1986 by The Economist that examines the relative over or undervaluation of currencies based on the relative price of a Big Mac across various countries of the world. Although it appears to be in jest, the Big Mac PPP is a fairly good starting point when measuring the purchasing power between currencies.
- The Big Mac PPP is an informal index used to compare the purchasing power between currencies as compared to the price of a McDonald's Big Mac.
- Another name for the Big Mac PPP is the Big Mac Index.
- Currencies are compared against the local price of a Big Mac in that nation's currency. Depending on the ratio, the currency could be considered over or undervalued.
What Is Purchasing Power Parity?
Understanding the Big Mac PPP
Purchasing power parity (PPP) is the theory that floating currency exchange rates will tend to go up or down in value to keep their purchasing power consistent across countries. This is based on the idea that identical goods should be expected to have a consistent value regardless of which currency that value is stated in. That is, if currency exchange markets are flexible and efficient, then currencies should tend toward parity in their local purchasing power relative to real goods and services.
This implies that if there is a substantial difference between the local price of a good in a given currency and the price implied by the currency market exchange rate, given the price of the good in other countries, stated in their local currencies, then the market exchange rate reflects something other than the true value of the local currency or that something other than market forces is influencing the exchange rate, local prices, or both.
If the PPP exchange rate of a currency implied by the local price of a given good or basket of goods is lower than the currency market exchange rate, then the exchange rate is overvaluing the local currency relative to its real purchasing power, and if the rate implied by the local price is higher than the market exchange rate, then the exchange rate is undervaluing the local currency.
The premise of the Big Mac PPP survey is the idea that the popular McDonald's sandwich known as the Big Mac is the same across the globe and can serve as a basic benchmark for purchasing power parity. Normally, when economists measure purchasing power parity they use the prices of a variety of consumer goods to construct a local price index.
Because the production, distribution, and sale of Big Mac's require a broad range of commodities, labor, and capital goods which remain fairly consistent from country to country because of franchise standards, the Big Mac is believed to be a good stand-in for a wide variety of prices and costs from one economy to the next. This makes the local price of a Big Mac a convenient proxy for the general level of local prices, which can then be used to estimate purchasing power parity for comparison to currency market exchange rates.
Big Mac PPP is also known as the Big Mac Index. The Big Mac Index measures purchasing power parity (PPP).
How to Calculate the Big Mac PPP
Big Mac PPP is calculated by examining the price of a Big Mac in a given country in its home currency and divides it by the price of a Big Mac in the second country, which is usually the United States. Let's say that we are looking at the Big Mac in China. If a Chinese Big Mac is 10.41 renminbi (RMB) and the U.S. price is $2.90, then—according to PPP—the exchange rate should be 1 USD for 3.59 RMB. However, if the RMB were actually trading in the currency market at 1 USD for 8.27 RMB, the Big Mac PPP would suggest that the RMB is undervalued.
Disadvantages of the Big Mac PPP
Something the Big Mac Index fails to take into consideration is that while the inputs of the Big Mac and the way the Big Mac is manufactured and distributed is uniform across all countries, the relative costs associated with the labor to staff the stores, the land rent of the storefront, the capital goods, and commodity ingredients needs and the additional costs within the franchise license to operate the McDonald's restaurant might be different across countries. This may sway the price of the Big Mac and throw off the ratio relative to the cost of the U.S. version.
Despite this, the Big Mac Index is still a good starting point in determining currency discrepancies. The Index is an example of how PPP is used, but should not be considered the definitive comparison tool.