The Big Mac Index and Global Currencies
March 21, 2019
Not everyone finds macroeconomics as riveting a subject as we do here at Nomad Capitalist, but thanks to the Economist Magazine’s Big Mac Index, concepts like Purchasing Power Parity (PPP) and the Law of One Price are more interesting and accessible than ever before.
1986 was an exciting year in the financial and economic world: Microsoft had its initial public offering, the British Government deregulated its markets in what became known as the “Big Bang,” and “Burgernomics” was born.
This article explores how the Big Mac Index is used today to determine and track a currency’s over- or undervaluation by comparing the different prices we pay for the iconic Big Mac burger around the world.
The Theory Explained
At its most basic, the Big Mac Index is a way to gauge a currency’s over- or undervaluation using the Law of One Price, Purchase Power Parity, and the cost of the iconic Big Mac.
The Law of One Price
The Big Mac Index is an example of how we measure the law of one price, which states that in the absence of any transport costs and trade tariffs and if free competition and price flexibility are present, identical goods will cost the same price regardless of where you purchase them (once converted into a common currency).
This seems pretty straightforward since you would expect to pay the same amount for an ounce of gold in Australia as you would in Zambia. However, we also know that a pint of beer in Geneva is going to cost way more than a beer in Warsaw.
Therefore, it seems that this may generally be true for commodities such as gold, but it doesn’t always apply to other goods. In theory, however, even when prices are not currently the same across borders, over time they should move towards the same price.
This follows from the assumption upon which the law of one price is based – any variations in pricing that exist between two separate locations will inevitably be eradicated once enough participants in the market begin to exploit arbitrage opportunities that exist.
Our regular readers might be familiar with the concept of geoarbitrage, a topic we have written extensively on. Geoarbitrage is based on the same concept as arbitrage, but it focuses on the disparities in labor costs between countries, noting how exploiting these disparities will deliver a greater return on your time.
For instance, if you wish to hire an online personal assistant, then you can save money by hiring someone from Eastern Europe since their wage requirements will be lower than someone from the US.
However, the arbitrage we are discussing here is slightly different, and it is generally applied to financial instruments. This type of arbitrage refers to any transaction that exploits pricing imbalances that exist for a tradable item between two or more markets. such as if you were able to buy a financial instrument in one market and sell it in another for a risk-free profit.
This arbitrage actually operates as an instrument that regulates pricing across markets because once the pricing imbalance is noticed by either or both markets, the pricing will likely be adjusted to eliminate the discrepancy.
The Big Mac Index applies to the Law of One price to the hamburger business.
Now, Big Mac burgers are not really all that susceptible to the practice of arbitrage, but they can provide a tasty example of how the concept works.
Here is a hypothetical scenario based on the figures released in the 2023 Big Mac Index to illustrate the concept:
A Big Mac costs $4.70 (R$22.90 ) in Brazil, while it costs just $3.99 (S14.90) across the border in Peru.
So, a McDonald’s restaurant that is situated on the Brazilian side of the border could potentially purchase all of its Big Macs from a McDonald’s situated on the Peruvian side of the border for $3.99.
Then, it could go on to sell those Big Macs to its Brazilian customers for $4.70, providing a risk-free profit of $0.71 a burger – until, of course, this behavior causes the prices to converge either by adjustments in the prices themselves, adjustments in the value of the currency, or both, resulting in purchasing power parity.
Purchase Power Parity (PPP)
So, what is purchase power parity? Well, as the above example implies, it is an economic theory that is founded on the law of one price.
To offer a somewhat superficial account, PPP provides that the exchange rate between two countries should be equal to the ratio of the respective purchasing power of those currencies. If this is not the case, then one of the currencies may be either over- or undervalued against the other currency.
Customarily, a “basket of goods” is used to determine purchasing power, but the burger-loving folks over at the Economist simplified things by placing just a single Big Mac burger in their hypothetical basket, making the concept a bit easier to digest.
Here is how the Economist Magazine applies this concept in their Big Mac index:
The cost for a Big Mac in Britain in 2023 is £4.19, or $5.21 if converted using the exchange rate of 0.78. In the United States, the same Big Mac cost $5.58.
We can attain an implied exchange rate, or PPP, by dividing the cost of the Big Mac in Britain (using the value in pounds sterling) by the price charged in the US (in USD).
So, 4.19 divided by 5.58 provides us with an implied exchange rate of 0.75.
To calculate to what extent one currency is over- or undervalued against another, you take the difference between the implied exchange rate and the actual exchange rate and then divide by the actual exchange rate.
In this case, 0.75 minus 0.78 gives us -0.03, and if you divide that by 0.780, we can conclude that the British pound is undervalued by around 3.4%.
Ronald McDonald and Macroeconomics
“Why a Big Mac?” you may ask. Well, although basing a macroeconomic analysis on a single fast food item might seem counter-intuitive and arbitrary, it actually makes a lot of sense.
For starters, McDonald’s has a phenomenally wide reach in the international community, where it serves close to 70 million people a day in over 100 countries.
The meteoric rise of this American burger institution is a truly astonishing story, and Forbes Magazine’s Global 2000 Ranking for 2023 shows McDonald’s once again retaining pole position as the largest restaurant chain in the world by revenue.
Another factor that makes the Big Mac a great candidate for this metric is that it is mostly produced to the same specifications throughout the world, which means – in theory at least – that the costs of producing the burger should be relatively standard across the globe.
Since the input costs involved in producing the Big Mac are located in several various sectors of the local economy – such as advertising, agriculture, transport, and labor – it could be argued that the burger is a lot closer to a “basket of goods” than it appears.
Although economists usually use a basket of goods to determine purchasing power, a burger comes surprisingly close.
However, the index is not without its critics.There are several factors that were not taken into consideration when calculating the Big Mac Index that could have caused potential inaccuracies. Here are a few of the limitations that exist in the methodology of the Big Mac Index:
First, the index has no way of incorporating considerations like the impact of taxation, local competition levels, or even the social status that is attached to dining at a fast food chain in a particular society.
Second, the popularity of the Big Mac will vary from location to location. As a result, McDonald’s may respond to this demand by pursuing a high-volume, low-margin strategy in locations where the Big Mac is popular, but in locations with fewer Big Mac orders, they may seek to generate more profit through higher margins.
Finally, while the reach of the Big Mac is astounding, there are some notable gaps in its availability in certain regions, particularly Africa. Only four of the fifty-four African countries currently bask in the illuminating glow of the golden arches – South Africa, Egypt, Morocco, and Mauritius.
Africa is home to around 18% of the world’s population, which means that many of them remain unrepresented by the Big Mac Index.
The Adjusted Version
In 2011, the Economist decided to address one shortfall in their Big Mac Index by offering an alternative index that has been adjusted to account for GDP per capita when assessing the fair value of a currency.
In July 2022 it was further updated to use the price McDonalds provides for the United States. They also changed how it calculates the GDP-adjusted index, which now follows the IMF’s GDP historical ratings.
Keeping in line with their culinary theme, they refer to this adjusted version of their raw index as the “gourmet version.”
Using a statistical tool called the line of best fit between GDP per capita and the price of a Big Mac, the Economist provides a more realistic view of a currency’s current fair value.
How to Use the Big Mac Index to Guide your Investments
The Big Mac Index can provide you with some fantastic insight into how various currencies may react in the future. However, just like any other investment strategy, it is important to practice the right amount of due diligence before acting.
In this section, we’ll undertake a superficial analysis of how the Big Mac Index has the potential to inform foreign exchange investments. As you read, keep in mind that this analysis is meant to get you thinking – it’s not professional investment advice.
Below, we analyzed the accuracy of the Big Mac Index using the figures released in 2011 and 2023 for a random selection of countries.
In this analysis, we use both the raw Big Mac Index and the “gourmet” Big Mac Index that takes GDP per capita into account.
Now, if you were operating a currency hedge fund, applying the principle of selling overvalued currencies (expecting their values against the dollar to decrease) and buying those that are undervalued (expecting their values against the dollar to strengthen), you might have made a few bad calls.
Working off the raw index, you might have been tempted to purchase the currencies of South Africa (undervalued by 49.7%), Egypt (undervalued by 53.1%), and India (undervalued by 54.5%%).
You most likely would have ignored Britain’s undervaluation of around 3.4%, and sold off the currencies of Switzerland (overvalued by 38.5%), Norway (overvalued by 24%), and Uruguay (overvalued by 22.9%).
However, when looking at three countries that were significantly undervalued against the dollar in 2011, you’ll notice that they depreciated further by 2023. The South African rand, for instance, has been in constant decline for the past two years, and political instability and record inflation in Egypt has continued to depress its currency value.
Interestingly, India – despite the exchange rate slipping markedly from 44.4 to 83.00 – actually held its margin of undervaluation steady from 53.5% to 54.5%. Upon closer inspection, however, you will notice that this is in fact due to a sharp spike in the Indian price of the Big Mac – the beloved burger cost 132% more in 2023 than it did in 2013.
Some of the currencies in the table that you would have potentially sold off – Norway, for example, – has, in fact, depreciated markedly against the dollar.
While you could technically use the Big Mac Index to guide your investments, it isn’t always on the ball. When examining the two indices, the first thing you are likely to notice is the remarkable difference between the raw index and adjusted index in relation to the over or undervaluation of currencies against the dollar.
The adjusted index also seems more reliable in predicting fluctuations in exchange rates.
Of course, and as is the case with statistics, they can often represent a myriad of contrasting phenomena depending on how, and by whom, they are used.
Based on the figures above, it certainly appears that the adjusted index is a more accurate account of a currency’s over- or undervaluation against another currency. Therefore, if you were to use the Big Mac Index to guide your trading decisions, the adjusted index is the safer bet.
Big Mac Prices around the world
At this point, you might be wondering which countries are the most expensive to buy a Big Mac in and which countries are the cheapest.
Below is a list of five countries where you will pay the most for a Big Mac and the five countries where you will pay the least.
Although the Big Mac Index isn’t an exact science, it can provide a rough indication of living costs from country to country, but as we have seen, there are a myriad of other factors involved that you need to consider when applying the results of the Big Mac Index.
The Five Most Expensive Countries
These are the most expensive countries to buy a Big Mac, based on 2023 figures.
SWITZERLAND: $7.48 (6.70 CHF)
Actual exchange rate = 0.87
Implied exchange rate = 1.20
Zurich, which is often cited as the world’s most expensive city, is also fittingly home to the world’s most expensive Big Mac. Factors that contribute to higher costs in producing the burger in Switzerland include relatively high wages and a heavy tax on imported goods imposed to shield and support local Swiss farmers.
Uruguay $6.77 (259 UYU)
Actual exchange rate = 37.77
Implied exchange rate = 46.42
Uruguay has the third most expensive Big Mac burger with a price tag of $6.77, which is the equivalent of 259 Uruguayan dollars. The cost of living there is among the highest in Latin America. According to the World Bank, Uruguay has the least inequality and the highest income in Latin America.
NORWAY $6.53 (70 NOK)
Actual exchange rate = 10.12
Implied exchange rate = 12.54
Norway is home to the second most expensive Big Mac burger in the world with a price tag of $6.53, which is the equivalent of 70 Krone.
Oslo is the most expensive city in the world in which to enjoy a pint of beer, and with the 2nd most expensive Big Mac, it looks as if a night out drinking and feasting on fast food may be quite a pricey affair.
This is partially thanks to Norway’s high wages and high cost of living. According to WorldData.info, Norway had the 3rd highest average salary in the world in 20233.
In the Big Mac Raw Index, the krone is overvalued by 24% while the Adjusted index reveals that the krone is overvalued by 22.3%.
UNITED STATES $5.58 (Base Currency)
At eighth on the list, the strength of the dollar means that you will pay less for the iconic American Sandwich almost anywhere else in the world, making it a good time to travel with the greenback in your pocket.
U.S food prices are naturally affected by the strength of the dollar. When the dollar is strong, exports of food for sale in overseas markets generally drop, which produces supply in the local market and effectively drives food prices down.
Another reason why the US Big Mac is comparatively more expensive is that this price is an average of all Big Mac prices in the US. There are significant fluctuations in the cost of living among states and cities, so Big Macs in expensive regions like New York City or the California Bay Area are naturally going to drive up the average.
The Cheapest Countries
On the other hand, here are the countries with some of the cheapest Big Macs in the world, and you might be surprised at who made the list.
TAIWAN $2.35 (75 TWD)
Actual exchange rate = 31.43
Implied exchange rate = 13.44
For many reasons, Taiwan has become an increasingly attractive destination for expats – particularly those looking to retire abroad in a country where the cost of living is comparatively lower.
The Taiwan dollar is undervalued by 57.2% according to the raw index, but the adjusted index has it slightly less undervalued at 56.8%.
EGYPT $2.62 (81 EGP)
Actual exchange rate = 30.93
Implied exchange rate = 14.52
Egypt has one of the cheapest Big Macs in the world at just $2.62.
Egyptian salaries are remarkably low, and steep price hikes in recent times have put more pressure on Egyptian citizens as basic services become increasingly expensive, including transport, electricity, and even drinkable water.
With the exchange rate sitting around 1 dollar to 41 Egyptian pounds, this is a great time to travel to Egypt and get yourself a Big Mac.
The Big Mac Index for 2023 shows the Egyptian pound undervalued against the dollar by a sizable 53.1%, with the adjusted index at a slightly less alarming 41.7%.
MALAYSIA $2.82 (13.5 MYR)
Actual exchange rate = 4.51
Implied exchange rate = 2.36
Political upheaval has plagued Malaysia in recent times, but this has not decreased this country’s attractiveness as a fantastic place to live thanks to its low costs of living (particularly for foreigners) and comfortably high quality of life.
In fact, the country is considered one of the best places in the world to retire, and according to International Living is ranked first for healthcare services and infrastructure.
Malaysians enjoy reasonably high life expectancy, subsidized healthcare, reasonably good education, and strong industries, such as electronic equipment, petroleum, and liquefied natural gas production, which all point towards Malaysia becoming a developed nation over the next few years.
Although the Malaysian economy is highly developed, it’s still home to the 5th least expensive Big Mac on the planet.
According to the Big Mac Index, the Malaysian ringgit is undervalued by a hearty 47.7%, but that number is drastically reduced in the adjusted index, which shows the currency to be undervalued by only 38.8% against the dollar.
Hong Kong $2.94 (23 HKD)
Actual exchange rate = 7.8
Implied exchange rate = 4.12
In terms of finding a stable, financially robust, and business-friendly location in Asia, Hong Kong is near the top of the list. This small island state, a gateway to Greater China, is a wealth haven for foreign capital.
You can still find cheap food in Hong Kong though, in fact it’s one of the best destinations for eating out in Asia. While the Big Mac may not compete in culinary terms, grabbing a quick bite under the golden arches in Hong Kong is certainly not going to break the bank.
If you want help designing a holistic plan to find the perfect tax systems and international structures to streamline and reduce your business and personal taxes, feel free to reach out.
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