The Economist magazine has been publishing, for the 24th year running, its Big Mac Index (BMI), which compares the cost of a Big Mac burger in different countries. Clements, Lan and Seah estimate that the cost of a full page ad in The Economist is around $50,000 (Rs 22.35 lakh today). They say that for the magazine to continue to publish the Big Mac Index year after year means that, at least in the view of its editors, it’s worth this opportunity cost. In their paper, Clements, Lan and Seah examine whether the Big Mac Index is indeed a good measure of the over-valuation or under-valuation of currencies.
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But first, they talk a bit about the way exchange rates are determined. The accepted theory is that of “purchasing power parity” (PPP). This theory states simply that the exchange rate is proportional to the ratio of the price levels in two countries. If prices in country A increase relative to another country B, then the currency of A should depreciate against that of B. The Big Mac Index, which measures the cost of a more-or-less identical basket of goods (this includes meat, cheese, bread, labour, rent, electricity—all the costs that go into the making of the sandwich) therefore measures exchange rates in PPP terms. According to the index, the exchange rate of say the British pound against the US dollar should be equal to the cost of a Big Mac in Britain divided by the price of one in the US. The deviation from this formula shows the extent of overvaluation/undervaluation of the British pound against the US dollar. The Economist publishes Big Mac indices annually for several currencies in this way.
The authors say, however, that the Big Mac Index is a biased one.
They point out: “There are substantial, sustained and significant deviations of exchange rates from the BMI.” For example, the index shows that eight countries—Australia, China, Hong Kong, Malaysia, Poland, Singapore, Russia and Thailand—have always had undervalued currencies.
On the other hand, the currencies of Britain, Denmark and Switzerland are always overvalued, according to the index. Write the authors: “These strings of persistent disparities over a fairly lengthy period in almost two-thirds of the cases raise serious questions about the credibility of the BMI as a pricing rule for currencies.”
Fortunately, they find that this defect can be corrected, and after making some adjustments for the bias, the index has predictive power.
That means a currency seen as undervalued by the BMI will in future gain against the dollar, while a currency seen as overvalued will depreciate. Simply put: Overvalued currencies subsequently depreciate, while undervalued ones appreciate.
The paper finds that after adjusting for the bias, the BMI “tracks exchange rates reasonably well over the medium to longer term in accordance with relative purchasing power parity theory.”
What’s more, the index is as good as the industry standard in predicting future currency values, except for short-term horizons.
India doesn’t figure in the BMI because most Indians do not eat beef. But next time you feel like punting on a currency, its Big Mac Index could tell you whether it is undervalued or overvalued. As the authors point out, given that all it takes is to buy a copy of The Economist, the index seems to provide good value for money.
Graphic by Jayachandran/Mint
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