What does a 540-calorie fast-food burger have to teach us about macroeconomics?
A whole lot, it turns out. Economists use a metric called the Big Mac Index to illustrate a powerful force in the world economy.
In 1986, venerable weekly The Economist invented a new way to understand exchange rates between one country’s currency and the next. The goal was to teach readers to ask and answer questions about exchange rates: How accurate are they? Is one country’s currency undervalued or overvalued? How can we tell?
To explore these questions, the writers leaned on a macroeconomic theory called purchasing power parity, or PPP. This theory holds that pricing for a single “basket of goods” will eventually level out from one nation to another. So, if a pound of rice is “worth” $2 in the United States, market forces will eventually bring costs to around the same amount in every currency.
But what fun is rice? The Economist substituted the Big Mac for the “basket of goods” in traditional PPP discussions, and they continue to publish the figures. The Big Mac Index started as a lighthearted way to demonstrate the theory of purchasing power parity, but it took on a life of its own. The Index worked so well that professors now teach it to economics undergraduates.
The Big Mac Index at Work
Economics can be complicated, and the Big Mac Index is a way to cut through the confusion. Here’s how it works.
In July 2017, the average price in U.S. dollars for a Big Mac was $5.30, reports The Economist. At that date’s exchange rate, Chinese citizens were only paying the equivalent of $2.92 for their Big Macs. The Big Mac Index, then, tells us that the Chinese yuan was worth more than the exchange rates gave it credit for. This currency was undervalued by 45 percent if the Big Mac Index is to be believed.
At the same time, the Swiss paid the equivalent of about $6.74 for a Big Mac. Because that’s more than a Big Mac costs in the United States, the Index would say that the Swiss franc is overvalued compared to the dollar—in this case, by 27.2 percent.
If you’re hungry for more, The Economist added a few more variables to create an adjusted index that might better reflect real-world economies.
“Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible,” The Economist reports, winking. “Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. For those who take their fast food more seriously, we have also calculated a gourmet version of the index.”
The Adjusted Big Mac Index
If the Big Mac Index seems like an oversimplification, that’s because it is. It doesn’t take into account the differences in Big Macs themselves from one nation to another. It doesn’t track the cultural forces surrounding McDonald’s. It skims over the fact that McDonald’s sets the price of a Big Mac, leading to instability in the Index.
The Adjusted Big Mac Index takes a more subtle criticism into account. Labor costs are lower in poor countries. You’d expect a Big Mac to cost less when the worker frying it gets paid less. So the designers of the Index incorporated a nation’s GDP per person, a metric that reflects the wealth of a nation generally.
“The adjusted index uses the ‘line of best fit’ between Big Mac prices and GDP per person for 48 countries (plus the euro area),” explains The Economist. “The difference between the price predicted by the red line for each country, given its income per person, and its actual price gives a supersized measure of currency under- and over-valuation.”
But What Does It Mean?
Well, the “line of best fit” is a statistical model that clarifies data on a scatter plot graph. The Adjusted Big Mac Index starts with such a graph, with the Y-axis representing the price of a Big Mac in U.S. dollars, and the X-axis representing GDP per person. Each nation falls somewhere on this graph, becoming a point in the scatter plot.
Then those at The Economist draw a red line of best fit following the placement of points on the graph. That red line becomes the predicted Big Mac price. With GDP per person thus folded into the equation, The Big Mac Index becomes more accurate.
For instance, the raw data shows that the Swiss Franc was overvalued by a whopping 27.2 percent compared to the U.S. dollar. The adjusted figure suggests that the Swiss France is only overvalued by 5.6 percent.
Phew
So there you have it: burgernomics. There are worse ways to discuss currency exchange rates, and besides, for a dry-as-dust economics concept, at least the Big Mac Index never fails to leave you hungry.
And if burgers aren’t your thing, you’ll be glad to know that some other consumer goods are used to show the economic trends. In 2004, The Economist and other news publications published a Tall Latte Index, which compared prices for a cup of Starbucks coffee—something that would come in handy as you study your economics textbook.
