I get a kick out of simple stories to explain complex ideas. So as part of my Global Business class for my Masters I was instructed to price index a Big Mac to explain the theory of purchasing power parity (PPP). The “Economist” does this annualy, but their results weren’t out for this year. I took today’s exchange rate and applied their math to get the following results. Call your financial advisor because the BIG MAC is giving us some investment advice…or so they say.
So how can there be such HUGE price variations in a Big Mac?
The price variations in a Big Mac between countries are a result of the purchasing power of a dollar in each country. The “Economist” has used the Cost of a Big Mac in recent years to explain PPP between two countries. Essentially, the exchange rates should even out the cost of a Big Mac around the world, however, the Big Mack Theory uses PPP to show how overvalued or undervalued a countries currency is.
PPP is a long term indicator, and in theory should predict which direction the currency will move in the future. For example if a Big Mac U.S. is 3.30 and in the UK it costs 3.90 then the PPP equation would look like this: 3.30/3.90 = .846.
If the actual exchange rate for the euro is lower than the implied PPP rate, the Big Mac theory suggests that the value of the euro might go up until it reaches the implied PPP rate. If the actual exchange rate is higher, then you might expect the euro to go down until it hits the implied PPP rate. (www.oanda.com)
Today’s exchange rate (as of 7/14/10)
|
Currency |
Code |
USD/1 Unit |
Units/1 USD |
|
Euro |
EUR |
1.2631 |
0.7919 |
|
British Pound |
GBP |
1.5104 |
0.6622 |
|
Japanese Yen |
JPY |
0.011309 |
88.4509 |
PRICE OF A BIG MAC INDEXED BY TODAY’S RATES (as of 7/14/10)
|
Country |
Big Mac Price |
Implied PPP rate + |
Today’s |
Over(+) / Under(-) Valuation against the USD, % ++ |
|||
|
in Local Currency |
in US dollars |
||||||
|
United States |
$ 3.57 |
3.5700 |
— |
1.0000 |
— |
||
|
Britain |
£ 2.29 |
3.4384 |
0.64 |
0.6622 |
-2.22 |
||
|
Euro area |
€ 3.31 |
4.1640 |
0.93 |
0.7919 |
13.81 |
||
|
Japan |
¥ 320 |
3.6077 |
89.6 |
88.4509 |
1.149 |
||
So, what can we conclude from this? Break out your wallets for investment. According to the theory we should short the GBP because today’s implied rate is above the PPP; and go long on the Euro and Yen because the PPP is higher than todays implied rate.
On a lighter note…I’m not sure whether to be excited about the fact that I just indexed a big mac and gave security advice (I am Series 7 licensed btw)..or to be a bit bashful about being such a nerd that I found that to be pretty fun.
References: www.oanda.com
Candace, I’m not sure I followed all of the math but it did call to mind living in Budapest, Hungary in the early 1990s. We had a McDonald’s two blocks from where we lived. The prices were roughly the same in the conversion to the dollar. The difficulty was in the comparison to incomes. I was in Hungary as an ESL teacher and made the equivalent of about $230/month (the average teacher’s salary in Hungary at the time). That Big Mac was a lot more expensive to me in Hungary than it had been as a teacher the previous year in North Carolina.
First off this post pretty much sealed my fate about wanting a Big Mac today. Secondly i suck at math but I hope it’s right as most of my IRA is euro based.
@ Jay
I lived in London for a while and we all know that conversion is not cheap. Anyhow, I lived on breakfast bars in the morning and waited until dinner to get a chicken and french fry fast food meal. At the time that was about 5.00 pounds…Problem? Well that was equivalent to about 9.50 USD at the time and I was a college student with a budget of about 1k for the whole summer.
Despite this and the use of public transportation and walking, I still managed to gain about 15lbs that summer. HAHA