Big Macs are all about international economics By Claudio Lizárraga In order to accurately compare economies using different currencies, economists had to figure out the right tools for the job. An ingenious solution to this problem was proposed by the magazine The Economist in 1986. Rather than a sophisticated instrument, the tool was easily relatable to any American: a cheeseburger. They called it the Big Mac Index. Its purpose is to measure and compare the purchasing power of two distinct currencies. In their own words, they were trying to make international economics a bit more digestible. For the economics connoisseur, this is just a modified, simpler version of the purchasing power parity theory (PPP). But what is that all about? Keep reading to find out. Purchasing power parity is a theory that states that, under free market conditions, the exchange rate between two currencies is at market equilibrium when their purchasing power is the same, that is, they can acquire the same amount of goods and services. How are economists able to determine this? Well, the rate of exchange of these currencies must match the ratio of the price level of a determinate basket of goods and services. If the exchange rate for any given currency is $0.50 then the prices for the same basket of goods must be half abroad. But that’s just the ideal PPP scenario, what happens when exchange rates deviate from these equilibria? Many factors, such as tariffs, taxes and other duties, may distort international markets and prevent them from reaching equilibrium. These misalignments may lead into either under or overvaluation of the currency in question. Now that you are more familiar with the theory behind it, we can bring up how the Big Mac Index fits into all of this. The peculiarity of this index is its basket of goods: it only includes one. If you want to take a wild guess, yes, we’re talking about the Big Mac. By taking the price of a Big Mac abroad and comparing it to the base American price we can derive an implied exchange rate, assuming a PPP scenario. That implied rate corresponds, in theory, to the equilibrium rate, and now we can compare this to the real world exchange rate. If the implied rate is lower than the actual exchange rate, it means that the currency in question is undervalued. In other words, you can purchase more Big Macs abroad. The same applies the other way around: if the implied rate is higher than the actual rate, it means you can purchase more Big Macs locally than abroad. Woah! Didn’t know burgers had that much to say about international economics. Say you’re having trouble getting a grasp of the PPP theory… just add some cheese and throw it in the grill!
