Big Mac Exchange Rate Theory
Roberto Chang
Econ 336
February 2012
The Law of One Price
• In Economics, we often postulate the Law of
One Price: the same good should sell at the
same price in different locations.
• Why? If not, there could be arbitrage: you
could make a profit by buying the good where
it is cheaper and selling it where it is more
expensive.
Limits to the “Law”
• Obviously, transportation costs may matter.
• But they may not be so important for “big”
items (i.e. cars)
• You might also find that people cannot easily
arbitrage due to e.g. legal issues
Nevertheless…
• Sometimes (often) economists believe that
the Law of One Price must hold at least in the
long run, provided one corrects for
transportation costs.
The Law of One Price in an
International Context
• One may also believe that the Law of One
Price should hold across countries as well.
• Now: goods are priced in different currencies
• So: one can postulate that exchange rates in
the long run adjust so that the Law of One
Price holds
 This will lead to a theory of exchange rates in
the long run
The Big Mac Theory
• A Big Mac is a standard, homogenous, product
• So it should sell for the same price
everywhere in the long run
• So, in a long run equilibrium, the exchange
rate should equalize prices of Big Macs in
different countries.
Current Big Mac Prices
• Price of a Big Mac in the US: $ 4.07
• In China: 14.7 Yuan
• Let x = the exchange rate (Yuan per $) that
makes the two prices equal. Then
14.7 Yuan = x times $ 4.07
i.e. x = 14.7/4.07 = 3.61 Yuan/$
Is the Yuan Undervalued?
• So, according to the Big Mac Theory, the
“equilibrium” Yuan/dollar exchange rate
should be 3.61
• Yesterday: market exchange rate is 6.30
Yuan/dollar
• So, according to this, the Yuan is about 43
percent undervalued relative to the dollar!
Big Mac Index, June 2009 (from The Economist)