J Brauer | © Stone Garden Economics

Since 1986, The Economist newspaper has produced its Big Mac index as a tongue-in-cheek check on whether a country’s actual foreign exchange (FX) rate is over- or undervalued relative to the US dollar. To do so, it compares a given country’s price of a McDonald’s Big Mac to the price of a Big Mac in the United States. This is on the (purchasing power parity) theory that the price of a globally standardized product such as the Big Mac should be the same everywhere. The FX-rate should reflect this equality of product prices. If it does not, then the FX-rate is either over- or undervalued.

For example, in January 2014, a Big Mac in Colombia was priced at COP8,600 (Colombian pesos) and USD4.62 in the United States. The rate of COP8,600-to-USD4.62 implies an FX-rate of COP1,861.47 per dollar. The actual FX-rate on the FX-markets, however, was COP1,982.80, meaning that the dollar bought 6.51 percent more pesos (COP1,982.80/COP1,861.47) than the burger-to-burger comparison implies. Put differently, the dollar is overvalued; it has “too much” purchasing power. (Conversely, the peso is undervalued by -6.12%).

Economic theory suggests that as the dollar has “too much” purchasing power, the U.S. will start to import more from Colombia as that country’s products are relatively cheap due to the peso undervaluation. In time, the additional supply of dollars (and additional demand for pesos) to conduct the extra trade will then cheapen the dollar (and strengthen the peso) such that the current FX-rate of COP1,982.80 per dollar should gradually move toward the implied rate of COP1,861.47 per dollar.

In other words, in the long run, the FX-market corrects itself.

The implied FX-rate is like a deep ocean current that pulls in a particular direction. However, there are a multitude of other factors—such as the underwater terrain, side currents, and surface winds—that reinforce or counteract the main current. And so it is in the FX-markets: In the short run, the actual FX-rate may deviate from the implied FX-rate.

Economists deem predictions about where the FX-rate will go “tomorrow” quite impossible, but in the long run the FX-rate is expected to move toward the implied rate as dictated by the two economies’ underlying economic fundamentals. (This holds for other financial and asset markets as well, as recognized by the 2013 economics Nobel Prize awards).

As to The Economist‘s burgernomics, for the past 10 years, the Colombian peso has in fact fluctuated around the implied FX-rate by +/- 20 percent, a substantial variation. For other countries, however—India, South Africa, and Ukraine, for example—the currencies have been undervalued for many, many years and show little sign of moving toward the implied rate. For others, Thailand for instance, the undervaluation also has existed for very many years but is at least moving toward the implied rate. Currencies for still other countries, Norway and Switzerland for example, have been overvalued for many years on end.

Burgernomics tracks but a single product, the Big Mac. It takes ingredient costs in account and also local wage rates and rental cost of the burger outlets. But pricing is not only about cost. It is also about what customers are willing to pay, and that will depend in part on their incomes and on product branding and competition in the local market. So, keep burgernomics light-hearted and treat it as a funny way to learn about FX-markets and purchasing power parity theory rather than as a way to speculate your way to fortune.

J Brauer is Professor of Economics, James M. Hull College of Business, Georgia Regents University, Augusta, Georgia, USA.

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