Tuesday, July 28, 2009

The Big Mac Index

I’m a bit late on this, but…it's been almost two weeks since The Economist published their most recent Big Mac Index. This can be an interesting tool to use when discussing exchange rates in your economics class. We often spend time explaining how exchange rates allow us to price and trade goods across national borders. And the easiest next step is to start taking local prices and converting them to foreign currencies using established rates.

But as the accompanying story explains, that should not be the end of the discussion. Exchange rates alone don't usually fully explain the prices of goods in different countries. The currencies themselves may not move freely within a market, or may be subject to other pressures depending on the state of the economy and expectations in still other countries. This explains why an index is used to measure these possible effects.

By using a standard commodity (in this case, McDonald's Big Mac), we can measure prices against a single good across many countries and see how those prices conform to differences in exchange rates. Prices that vary significantly from simple exchange rate prices are either over-valued (too strong - benefitting importers in those countries and hindering exporters) or under-valued (too weak - benefitting exports and hindering importers). That can then be used in conjunction with the balance of trade for countries to see if there is an effect.

For those of you who teach exchange rates, do you integrate the Big Mac Index and does it help? I look forward to your comments.

This post references the following Keystone Economic Principles:
3. All choices have consequences.
4. Economic systems influence choices.

1 comment:

Andy said...

I've always wished The Economist would include a more comprehensive estimate of PPP along with the Big Mac calculation, like from the IMF or something. But I suppose that might detract from the gimmick.