The Big Mac Index

Topics: Purchasing power parity, Exchange rate, Inflation Pages: 4 (1248 words) Published: March 5, 2012

The Big Mac index is published by the Economist, It is purely based on the theory of purchasing power parity (PPP) the notion that in the long run exchange rates should move towards the rate that would equalise the prices of a basket of goods and services around the whole world. In simple words we take a ‘MacDonalds Big Mac’ as the benchmark and compare its price in the 120 countries in the world where it is sold and produced. Let us take an example, suppose the price of a Big Mac in the U.S is $3 and for the same burger in the UK it is £2. Looking at this the exchange rate would be 3 divided by 2 which would give us 1.5. Now if the exchange rate of dollars to pounds was greater than 1.5 it would mean the pound was overvalued and less than 1.5 it would be undervalued.

According to the index above average price of a Big Mac in the US is $4.07, In Malaysia it is $2.42 at the market exchange rates which means it is 40% cheaper. To make both the prices equal it would require an exchange rate of 1.77 to the dollar (Ringgit 7.20 divided by 1.77). This also suggests that the Malaysia Ringgit is undervalued by 40% against the dollar. Since the index is based on PPP we now look at what it means and the two types of conditions that go with it. STUDENT NUMBER: 092008164 Purchasing Power Parity is a condition between countries where an amount of money has the same purchasing power in different countries. The prices of goods between countries would only reflect the exchange rates. Identical products sold in different markets will sell at the same price when expressed in terms of a common currency in the presence of a competitive market structure and absence of transport costs and other barriers to trade. PPP is based on the ‘Law of one price’ which is based on the idea of perfect good arbitrage. Absolute Purchasing Power...
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