The Big Mac Index: A Shortcut To Inflation And Exchange Rate Dynamics? Price Tracking And Predictive Properties

Abstract

The Economist magazine has been publishing the Big Mac Index using it as a rule of thumb to determine the over- or under-valuation of international currencies based on the theory of Purchasing Power Parity since 1986. According to the theory, using the Big Mac as a tradable single-good basket, the Dollar-value of the hamburger should be equalized around the world due to arbitrage. The popularity and following of the Big Mac Index led the authors to the following two questions: 1) How effective is the Big Mac price as an indicator of overall inflation? and 2) how accurate are exchange rate movement predictions based on Big Mac prices? They find that Big Mac prices tend to lag overall inflation rates, which is highly important in studies that use Big Mac prices as measures of affordability or real incomes over time. As a guide to exchange rate movements, there is support for the theory of Purchasing Power Parity, but only as a qualitative indicator of movement in the nominal exchange rate in rich and economically stable countries, proving less effective in forecasting exchange rate movements in emerging markets. The statistical analysis is carried out using data from 1986 to 2012 from The Economist and from the World Bank for 54 countries. The importance of these findings lies on the widespread use of the index and thus perpetuation of perceptions on the relative value of currencies in the areas of corporate finance, international trade and finance, and international business.