The Big Mac index was invented in 1986 by one of the editors of the economist newspaper. Initially it was considered a lighthearted theory of the exchange rate introduction. The impact resulting from the use of this theory around the world has had its share of benefits and abuse as the burgernomics enters the third decade of operations around the globe (The Economist, 2010).
The burgernomics argument is based on the perception in the international trade and economics that advocates for the theory of the purchasing-power parity (PPP). The theory is of the argument that the price of the commodity between two countries should be the same and the exchange rate should have minimal deviation. In the instance at hand, the basket can be looked at the MacDonald’s Big Mac that is produced in over 120 countries around the world (The Economist, 2010). The Big Mac PP would yield in principle an exchange rate that would make the cost of the Burgers in the America the same as elsewhere in the globe. The overvaluation or undervaluation of the currency can be obtained by looking at the exchange rate and the PPPs.
Table 1 and table 2 below shows the Big Mac prices in 2009 and 2010.
Table 1: BIG MAC PRICES in year 2009
Source: The Economist, 2010, p. 2
Looking at the values given in 2009 for the BIG Mac prices, the Big Mac in Brazil costs 8.02 real, against the market average price of 3.54 dollars. And thus to harmonize or make the two prices equal will require an exchange rate of 2.27 real against the dollar compared with the actual market rate of 2.32 and thus the Brazil real is undervalued by 2% against the dollar. In China, the Big Mac costs 8.02 Yuan whereas the average price is of 3.54 dollars and this will require adjustment of the exchange rate to be 3.53 Yuan against the dollar, which is far lower that the real market rate of 6.84 Yuan against the dollar and thus the Chinese Yuan is undervalued at 48% against the dollar.
In the case in Germany, the Big Mac costs € 3.42 against the actual price of 3.54 dollars. To harmonize the prices to attain the equality the exchange rate will be adjusted to be €1.04 against the dollar which is far above the market exchange rate of €1.28 against the dollar and this represents the overvaluation of the Germany € at 24% against the dollar. The same argument when applied we see that in Japan the Big Mac is going at 290¥ and the real price is 3.54 dollars.
In this connection, to attain the equilibrium the exchange rate has to be adjusted to be 81.9¥ against the dollar which is far below the market rates of 89.8¥ against the dollar and this generally represents an undervaluation of the Japanese ¥ by 9%. In 2009 we can conclude that Big Mac price index presented scenarios where overvaluation was reported in German € exchange against the dollar by 24%, undervaluation of the Chinese Yuan by 48%, undervaluation by 2% against the Brazil Real and an undervaluation of 9% against the Japan Yen.
Table 2: BIG MAC PRICES in year 2010
In 2010 we are witnessing a different scenario where the Big Mac prices gives an overvaluation of the Brazil Real by 31% against the US dollar, another overvaluation by 16% of the Germany € against the dollar , the undervaluation of the Chinese yen by 48% against the US dollar and the Japanese yen was undervalued by 2% against the dollar.
Though it is a challenge for any government to control the stability of the country’s currency, it is also its mandate to protect the interest of the citizens in the country. It is advisable to have a lower exchange rate that will encourage good domestic economy. This will be essential in minimizing the likely effects of over-reliance on the external factors in the development of the economy. The weak currency will boost the export and thus encourage domestic production.
Conclusion
The use of the Big Mac prices around the world and PP Exchange rates in predicting the future exchange rate may be a trick affair as the Big Mac prices are determined by many factors and some of the externalities are very volatile in behavior. If we take the example from the 2009 and 2010 Big Mac prices, we realize some variation that cannot be easily put into a viable model. We see the Brazil real being undervalued at 2% against the dollar in 2009 and the same currency is being overvalued in 2010 by 31% against the dollar. During the same period, the Chinese Yuan is undervalued at 48% against the dollar and thus the two present very different circumstances and it will be difficult to use the arguments presented to give the trend may be in 5 or 10 years down the line.
Reference
The Economist. (2010, April). Big Mac Index. Markets & Data, pp. 1-3.