Its inventor intended it more as a joke, but it is now world-famous: the Big Mac Index. What is it all about? It is a simple, but at the same time extremely effective method of comparing the purchasing power of currencies. From this, in turn, conclusions can be drawn about possible undervaluations and overvaluations. Here you can find out how it works - and what else the index can do.
Once upon a time in 1986: the history of the Big Mac Index
The Big Mac Index was invented in 1986 by the economist Pamela Woodall, a journalist for the renowned business paper "The Economist". The idea behind it: To find a not entirely serious rule of thumb with which to estimate the valuation of currencies. The Big Mac Index is based on the theory of purchasing power parity (PPP). It assumes that in a perfect market a uniform good costs the same in two different countries. Why was the Big Mac chosen as the basis? Because the legendary McDonald's burger exists in over 100 countries in almost identical form.
The model is, of course, highly simplified: for example, it does not take into account trade barriers such as customs duties or transport and insurance costs. Nor does it take into account different wage costs and demand situations. Consequently, the well-known fast food indicator can only provide a rough estimate.
The Big Mac Index as a purchasing power indicator for currency comparison
And this is how a possible over- or undervaluation of currencies can be determined in exness download: First, the implicit theoretical exchange rate is determined by comparing the average burger prices in two countries or currency zones. This is the exchange rate that should apply according to the theory of purchasing power parity. Subsequently, a comparison with the actual exchange rate provides information on over- or undervaluation. To illustrate, here is an example using Big Mac prices in July 2021:
Big Mac price in the Eurozone: 4.27 euros
Big Mac price in the USA: 5.65 US dollars
This results in an implicit theoretical exchange rate of: 5.65 US dollars / 4.27 euros = 1.32
However, the actual exchange rate at that time was 1.18. So per euro you got less US dollars than the theoretical exchange rate suggests. This indicates an overvaluation of the US dollar.
Now the following formula can be used to calculate the percentage over/undervaluation:
[(Theoretical exchange rate - actual exchange rate) / actual exchange rate] x 100 %.
Substituting: [(1.32 - 1.18) / 1.18] x 100 % = 11.86 %.
The US dollar is therefore 11.86% overvalued against the euro and the euro is correspondingly undervalued.
If this is too time-consuming for you: With the online tool of "The Economist" you can determine the over/undervaluations of many currencies. Note that the tool works internally with more than two decimal places for the exchange rates. That is why the result there (12.5 %) is slightly different from our example.