The Big Mac Index is a tool created by economists to compare the affordability of goods across different currencies. First published in 1986 – and annually ever since – it’s generally seen as a light-hearted way to measure purchasing power parity, though it still has some practical uses for investors.
What is the Big Mac index?
The Big Mac Index, or the Big Mac PPP, uses the price of a McDonald’s Big Mac burger as a benchmark to measure purchasing power parity (PPP) – the idea that with the right exchange rate, consumers in all locations should have the same purchasing power – between nations. It was invented by The Economist in 1986 and the magazine has published it every year since then. The Big Mac was chosen because it is a global product made up of the same ingredients in every country it is served, with only a few exceptions. The basic notion is that the price of a Big Mac in each country should be able to tell us something about the wealth of that nation.
How does this index work?
The Big Mac Index is calculated by dividing the local currency price of a Big Mac in one country by its price in another to arrive at an exchange rate. This exchange rate is then compared to the official exchange rate between the two currencies to determine if either currency is undervalued or overvalued.
If a Big Mac in the US costs one US dollar and one in the eurozone costs two euros, the Big Mac Index valuation for EUR/USD would be 2.0, or two divided by one, which could then be compared to the EUR/USD exchange rate. If the EUR/USD exchange rate was 1.5, investors might conclude that the euro is undervalued by 0.5 euros per US dollar.
The index in action
The latest Big Mac index (2021) revealed that the Lebanese pound was the most undervalued currency in the world. It was shown to be undervalued by 69% against the US dollar. It also revealed that most currencies lost ground against the dollar over the past six months, with only the Swiss (29%), Swedish (13%) and Norwegian (7%) currencies being overvalued. The euro (-9%), the Australian dollar (-12%) and the British pound (-22%) were all shown to be undervalued.
How can it be used by investors?
The Big Mac Index can be used by investors to determine if a currency is overvalued or undervalued relative to others before making trading in the foreign exchange market based on that data. Investors can also measure changes in values over time to determine rates of inflation and compare that to official records. The index is also especially useful in countries where reliable indices aren't available, such as those that manipulate government statistics or those that don't publish official data. In these countries, investors may have trouble comparing consumer inflation to the exchange rate.
One flaw with the index is that while the way the manufacture and distribution of the Big Mac is the same in every country, the cost of the labour to staff the stores, the cost of the storefront, additional costs within the franchise license to operate the McDonald's restaurant and costs to import/acquire the inputs might be different across countries. Prices of Big Macs can also vary greatly between different areas within a country. For example, a Big Mac sold in a major city might be less expensive than one sold at a McDonald's located in a rural area. This may sway the price of the Big Mac and throw off the ratio. Despite this, the Big Mac Index is a functional starting point in determining currency discrepancies.
The KFC Index
One other flaw in the Big Mac Index is that McDonalds does not have a presence in every country. In Africa, McDonald’s is only present in three countries: Morocco, South Africa and Egypt. KFC, on the other hand, is operating in 20 African countries. This is the highest of any international fast food chain and is therefore a more applicable benchmark to use for indicating PPP in African countries. Working in the same way as the Big Mac Index, the goods covered in the KFC Index is KFC´s Original 12 Piece Bucket. The KFC Index also covers the United States, France, Spain and the United Kingdom.
The bottom line on the Big Mac Index
The Big Mac Index succeeds in its goal of simplifying purchasing price parity. While not a definitive tool, it is used by many traders, including those looking to start investing in foreign exchange.