Saturday, February 20, 2010

Big Mac Index Explained----

The Big Mac Index is a creation of The Economist magazine...It is a measurement of an important economic concept called Purchasing Power Parity, or "PPP" for short.  PPP suggests that over time the prices of similar goods SHOULD be relatively EQUAL in terms of the purchasing power of the local currency it takes to buy it, REGARDLESS of the currency or country it is sold in.  It is by no means a perfect measurment and there are many variables that may account for differences in costs of producing a Big Mac in, say, New York compared to Mexico City. However, it gives as some idea of what exchanges SHOULD be and then we can compare them to what the REALLY are in the Foreign Exchange Market and determine if currencies are over-valued or under-valuded relative to each other....Here is an example:

The Economist uses a Big Mac price of $3.57 in the US. A Big Mac in the Euro area costs €3.31. If we take the Big Mac in Euros divided  by the price in Dollars we will get a PPP exchange rate of Euros in terms of Dollars---€3.31/$3.57 = €.927.  This means, according to PPP, $1.00 will exchange for €.927 and the reciprocal, €1.00 will exchange for $1.078.  What is the ACTUAL exchange rate in the FOREX?---$1.00 = €.739 or €1.00 = $1.353. To find out what a Big Mac will actually cost dollar holders, we take the Big Mac price in euros, €3.31, and multiply it by actual exchange rate of $1.353 which equals $4.48! AND if a holder of Euros exchanges their Euros for Dollars to buy a Big Mac in the US, they will pay $3.57 multiplied by the actual exchange rate of €.739 which equals $2.69! Not a deal for holders of dollars BUT a deal for holders of Euros....

The basic formulas you need to know...
(1) To find PPP take the Big Mac Price in the local currency and divide it by the Big Mac Price in Dollars ($3.57 everytime)
(2) This will give the foreign currency price per dollar (in PPP), or "How many ___(insert name of currency) does it take to buy $1.00".
(3) Take the reciprocal of the number you found in (2) to determine "How many dollars does it take to buy___(insert name of currency)"
(4)...(2) and (3) give you the PPP exchange rate
(5) Find the ACTUAL exchange rate for (1) a dollar to buy ___(corresponding currency) and  (2)___(corresponding currency) to buy a dollar. In our example above--a dollar bought €.739 and a euro bought $1.35.
(6) Take the actual exchange rate for a holder of dollars (in our example we had to pay $1.353) to buy the currency and mulitply it by the Big Mac price in the foreign country to get how much in dollars the Big Mac will cost you.
(7) Take the actual exchange rate for the foreign currency (in our example they had to pay €.739) to buy a dollar and multiply it by the Big Mac price in the US (always $3.57) to find out how much in dollars it will cost the foreigner to buy a Big Mac in the US.

Examples for you to work:
Country          Price of Big Mac in this country
Mexico             33 Pesos
China               12.5 Yuan
Britain              2.29 Pounds
Norway            40 Kroner
S. Korea           3400 Won
Pakistan            190 Rupee
Japan                320 Yen

Go through each question above, 1-7 and answer accordingly
To check your work CLICK HERE.
Go HERE for current exchange rates
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