By Devika Mathur, Edited by Vaibhav Agarwal
While just the name of a Big Mac can successfully water your mouth, in September of 1986, it raised an idea in the mind of Pam Woodall, for The Economist. The Big Mac Index, light-heartedly aims to determine the 'correct value' of currencies against each other, and determine how under or overvalued they are. The index develops on the concept of Purchasing Power Parity (PPP), and the notion that in the long run, the exchange rates should work in a way, such that the prices of identical baskets of goods and services (in this case, A Big Mac) are equalized in any two countries. While the index might not be an apt gauge of the exchange rates, it surely has gained considerable limelight in recent years and has made its way into several textbooks, and academic studies.
To have a better understanding of the index, let's consider an example, comparing the US Dollar and the Indian Rupee. As of January 2022, a Big Mac costs 190 rupees in India and US$5.81 in the United States. The implied exchange rate is 32.70. The difference between this and the actual exchange rate, 74.62, suggests the Indian rupee is 56.2% undervalued.
Source: The Economist
While this might seem irrelevant or humorous at first, the big mac is not just any other commodity. With its ingredients and preparation being the same in almost all the 118 countries it's sold in, it can be indicative of the price of ingredients, local wages, and other expenses, like marketing, in different countries.
As the Big Mac Index started to gain popularity, many organizations tried to come up with their version of the index. In January 2004, The Economist came up with the 'Tall Latte Index', which very similarly compared the price of Starbucks Tall Latte drink, to compare their exchange rates. Post this, in 2007, an Australian securities firm Commonwealth Securities, came up with the 'iPod Index'. Again developing the index on the concept of PPP, this time they pegged the exchange rate on the price of an iPod, which is not indicative of wage rates, or local costs, but rather is a tradable commodity. With an idea that at that time, all the iPods were manufactured in China, the price should be consistent across the nations, making it a better determinant for exchange rates. While the real-life scenario differs from this theory, this index aimed to attach the exchange rate to the value of a commodity that is tradable, and should be ideally equivalently priced in all the countries in question
Next into the frame was Bloomberg L.P.’s ‘IKEA’s Billy Bookshelf Index'. In September 2009, they compared the listed prices of the bookshelf from the IKEA website in 38 countries. On converting the prices into US Dollars, they analyzed that the world average price was $60.09, at that time, and the cheapest one could be found in the UAE, costing $47.64. The purpose of comparing the prices of the bookshelf was that it was a durable good, unlike a big mac burger, and wasn't purchased as often
Next was the 'Gold Mac Index' in which the purchasing power of gold was analyzed. For this, it was calculated how many burgers could an individual buy with 1 gram of gold. Later, the Swiss Bank expanded the scope of the Big Mac Index to include the amount of time that an average local worker in a given country must work to earn enough to buy a Big Mac.
In 2017, Versus came up with their version called the 'Chai Latte Global Index', comparing the prices of Starbucks' Chai Latte prices. After this, in 2019, Finder, a global personal finance comparison website released a more comprehensive version of the 'Starbucks Index', trying to conclude an exchange rate with the help of the price of a tall latte in 76 countries. Their latte-line suggested the correlation between the price of coffee and the country's GDP.
Even though the Big Mac Index has had a reasonable acceptance across the globe, it still has its fair share of limitations. One of the major concerns is geographical coverage. This is because McDonald's and its franchisees aren't present everywhere, leaving a large global area excluded. For instance, McDonald's can only be found in Morocco, Egypt, and South Africa, in the African region, thus they had to come up with the 'KFC Index' which works very similar to the Big Mac Index, but compares the price of KFC's original 15 piece chicken bucket, instead of the burger.
Apart from this, in many countries, dining at Mcdonald's is considered expensive, and eating at a local restaurant might be more economical. For instance, the demand for Big Macs in India might not be as large as in the US. Hence, it doesn't stand as globally acceptable.
The third criticism is that the price of a Big Mac burger will be dependent upon local production, delivery cost, advertising costs, transportation costs, and the status of the local market, which will be different among countries and not be a reflection of overall relative currency values. The GDP-adjusted variant of the index, released by The Economist addresses this criticism.
In addition to this, there is no theoretical reasoning behind why non-tradable goods and services such as property costs should be equal in different countries. The relative cost of high-margin products, such as essential pharmaceutical products, or cellular telephony might compare local capacity and willingness to pay, as much as relative currency values. Other than this, the strategy that Mcdonald's might choose to maximize their profits might also impact the pricing in that country. Lastly, even within a country, the price of a Big Mac can change as we move from one part to another.
To sum it all up, even though these indices might have their loopholes and criticisms, they have surely made understanding complex economic concepts like ForEx easier for the public.