The recent data from the Big Mac index indicated that, in New Zealand a Big Mac costs $6.60 NZD. However, in the United States it costs $5.71 USD. As Stuff.co.nz notes this implies an exchange rate of 1.16 in USD/NZD terms (a US dollar is worth 1.16 NZ dollars) if the price of the Big Mac is the same in both countries.
But instead google tells us the exchange rate is 1.51, and so the New Zealand dollar appears approximately 23% undervalued. But is that true? Should global currencies adjust to set the price of Big Macs equal in every market on earth? Let’s think about that a bit more below.
What is the Big Mac Index?
The Big Mac index is a light-hearted measure introduced by the Economist to underpin the “law of one price” and associated purchasing-power parity theory(PPP) of exchange rate determination. The PPP theory states that the exchange rate is proportional to the ratio of price levels in the two countries in each country.
At the current exchange rate a Big Mac in the United States would cost $8.62 NZD – compared to the reported $6.60 NZD it costs if it is purchased in New Zealand. In this instance there appears to be the potential for arbitrage – a Kiwi could purchase a whole lot of Big Macs in New Zealand, ship them to the United States, and then sell them for a $2 profit.
If Kiwi’s started to do that they would ultimately want NZD so they can buy goods and services here, so the US customers purchasing the product will demand more NZD in order to buy these cheap burgers. Furthermore, as US customers will start buying from Kiwi’s instead of domestic Big Mac providers the demand for USD to buy these burgers will fall. The increase in relative demand for NZD will then lead to an appreciation in the currency, which will reduce the incentive for Kiwi’s to export their Big Macs. This incentive disappears once the price of Big Macs are the same.
This is the assumption behind the “undervaluation” in the Big Mac index.
How it fails and what that tells us
If Big Macs were perfectly tradable, with no transportation costs, and without any complication of competitive issues, then the Big Mac index would provide a clear measure of PPP.
But this isn’t the case. Instead there is an observation that higher income countries tend to have higher prices – including for Big Macs. This regularity is termed the Penn Effect, and thinking about the Big Mac index can give us a way to understand why this occurs in general.
A Big Mac cannot easily be transferred across borders, and even with the same inputs it needs to be constructed in the market using domestic labour. This is a “non-tradable” component. If wages for domestic workers are higher – say because of higher domestic productivity in general bidding up wages in all sectors – then this non-tradable component will cost more than in low wage countries. Related to this is regulation – with taxes, minimum wages, and minimum employment standards all potential reasons why the burger might cost more in a given country.
Furthermore, the parts of the Big Mac that are traded may end up costing more in a country like New Zealand than other similar countries – as we are distant from the market and so there are potentially high transportation costs.
Finally, competition against the Big Mac differs between countries. In New Zealand Big Macs are generally seen as somewhat of an inferior good, and plenty of other options are available. However, in some countries certain sections of demand (think Western visitors to South East Asia who desperately want a burger) may find a Big Mac is the only burger on offer – leading to higher prices due to market structure.
So what is the use?
There are three ways that the Big Mac index is still useful – even if it is imprecise.
- Changes in the Big Mac index through time can be indicative of changes in under/over valuation. The NZD was noted as overvalued in 2014 and has since become significantly undervalued. With changes in relative productivity limited, NZ and US wages rising by similar amounts, and the terms of trade little different, this change suggests that either the NZD was overvalued in 2014 – or is undervalued now.
- Persistent differences can bear a relationship with real income differences – a number of the countries that are very “undervalued” also have lower average wages, productivity, and GDP per capita than many high income countries. As a result, it isn’t that the currency is undervalued that drivers the difference in the index – but a difference in the relative productivity of the nation.
- It is a clear way of communicating the law of one price with an everyday product that is homogenous across the globe.
So while enjoying the light hearted discussion the Big Mac index – we need to remember there are good reasons why your burger might be much cheaper (or more expensive) than a burger overseas.