Big Mac Index: An Imperfect but Popular Measure of Purchasing Power Parity

Running head: MANAGERIAL FINANCE
Managerial Finance
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Contents
Introduction:....................................................................................................................................2
Practice in Big Mac Index:..............................................................................................................2
Evaluation of exchange rates:..........................................................................................................2
The item or goods to be used for evaluation of exchange rates of two currencies must be
available in both the countries:....................................................................................................3
The demand of the goods are similar in both the countries:........................................................3
Supply of the goods or products subjected to such evaluation are similar in both the countries:
.....................................................................................................................................................4
No other factors affecting the demand and supply of consumers for a product:.........................4
Evaluation of the index based on the prices of certain products:....................................................4
Reasons of terming Big Mac Index imperfect as best:....................................................................7
Conclusion:......................................................................................................................................7
References:......................................................................................................................................9

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Introduction:
In order to measure the Purchasing Power Parity (PPP) between nations that use the
prices of Big Mac of McDonald as the benchmark, the Economist Magazine conducts a survey
known as Big Mac Index or Big Mac PPP. The Big Mac Index is based on the concept that any
changes in exchange rates are commensurate with the changes in prices of basket of goods.
Though it is an informal way of measuring PPP between two currencies but over the years the
index has achieved significant amount of popularity for its effectiveness.
Practice in Big Mac Index:
The simple logic of the Big Mac Index theory is that changes in exchange rates between
two currencies should effect the consumers purchasing Big Mac with one of the currencies in a
particular nation. The index measures the PPP and reveals whether a particular currency is
overvalued, undervalued or at a level with that of another currency by using the prices of a
particular product in those two different currencies (Clements, Lan & Seah 2012).
Evaluation of exchange rates:
Suppose a Big Mac hamburger is priced $5.00 in the US whereas it is being sold at
AU$6.00 in Australia. According to Big Mac Index the expected exchange rate should be
AU$1.20 for each US $(6.00/5.00). In case the exchange rate for AU$ is any greater than
AU$1.20 for $1.00 then according to the index, Big Mac Index, the US$ is overvalued and the
AU$ is undervalued (San Vicente Portes & Atal 2014).
Hence, from the above it is clear that the PPP is used informally by the Big Max Index to
evaluate the exchange rates between two currencies. The theory makes it very simple to evaluate
the changes in exchange rates but the question remains is measuring the exchange rates

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differences so simple and can it be measured from simple PPP of hamburger of McDonalds? A
detailed discussion on the Big Mac Index in this document shall be helpful in assessing the
justification of the theory used in the index of Big Mac (Tate, Ellram, Schoenherr & Petersen
2014).
The Purchasing Power Parity theory:
The Purchasing Power Parity theory used in the Big Mac Index has used certain assumptions and
if these underlying assumptions do not hold in the future then the evaluation of changes in
exchange rate between two currencies will not be appropriate using this theory. The assumptions
are as following:
The item or goods to be used for evaluation of exchange rates of two currencies
must be available in both the countries:
Firstly, the assumption is that the particular good or item to be used for calculation of exchange
rates differences between the two currencies are available in both the countries of whose
currencies are subjected to such evaluation under the index (Economist 2014).
The demand of the goods are similar in both the countries:
The index assumes that the demand for the particular product or item are similar in both the
countries. It is important to point out that rarely such phenomenon happens where the demand
for a particular product or item are similar in two different countries using two different
currencies (Atal 2014).