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The Big Mac Index

Written by A Forex View From Afar on Sunday, July 06, 2008

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Classic financial theory states that any given asset should have the same price anywhere in the world.

But things don't work this way it seems, identical assets have different prices from country to country. Economists like to put these different values on the currency shoulders, considering expensive assets are backed by over-valued currencies.

This analysis is called Purchasing Power Parity (PPP) and is used to measure the influence of the exchange rate over the same asset in two different countries.

Editors from the Economist found a unique way of measuring the PPP by using a matchless asset, the Big Mac. The hamburger was chosen due to world-wide spread and availability. The Big Mac index was started in 1986 and is measured annually, showing which currencies are over/under valued.

Big Mac Index

The swings in the Big Mac index takes years to happen, if ever, so this is why the index is often avoided by currency traders, who focus more on short term trades. Using this for real world trades, the 2007 Big Mac Index showed that the most overvalued currency was the Icelandic kroner, by 123%, against the dollar. This is quite interesting, since recently the kroner was hit by a currency crisis, depreciating at a very fast pace.

The most undervalued currency in 2007 was the Chinese yuan, by 55%. No wonder the Chinese government was accused of manipulating its currency to help exporters.

The Big Mac Index has its own limitations too. The price of a McDonald's meal depends on a lot of variables. Just to name a few: taxes, competition, import functions.

The Big Mac can be a good long time indicator for the currency trends, but these imbalances take years to correct and most importantly, the price of eating out at the local Mac doesn't represent the whole economy.

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