What is the Big Mac Index?

Ah, the Big Mac index. This is a fascinating concept that allows us to examine the purchasing power parity of different currencies around the world. Let me break it down for you.

The Big Mac index was first introduced by The Economist magazine in 1986 as a tongue-in-cheek way to compare the relative value of currencies. The idea is that the price of a Big Mac in different countries can give us an indication of whether a currency is overvalued or undervalued.

The index is based on the principle of purchasing power parity (PPP), which suggests that exchange rates should adjust to equalize the price of a basket of goods and services in different countries. In this case, the basket of goods is just one item - the Big Mac.

So, let's say that a Big Mac costs $5 in the United States and 500 yen in Japan. If we assume that the exchange rate between the US dollar and the Japanese yen is 1:100, then we can calculate that the Big Mac in Japan should cost 500 yen ÷ 100 = $5. This means that the PPP exchange rate between the two currencies is 1:1, which suggests that the currencies are fairly valued against each other.

However, if the actual exchange rate is different from the PPP rate, this suggests that one currency is overvalued or undervalued. For example, if the exchange rate is 1:80, then the Big Mac in Japan is cheaper than it should be relative to the US, which suggests that the yen is undervalued.

Of course, there are many factors that can influence exchange rates besides PPP, such as interest rates, inflation, and geopolitical events. But the Big Mac index provides a fun and accessible way to understand the basics of currency valuation and the principles of purchasing power parity.