What is the Big Mac Index?
Created by The Economist, the Big Mac Index measures purchasing power parity (PPP) across borders. PPP is an economic metric used to compare nation’s currencies by comparing the costs of a “basket of goods”, i.e. how much does a basket of goods cost in Denmark versus a basket in Vietnam. According to the PPP theory once exchange rates are considered, the goods should cost approximately the same. To form an accurate PPP measure, a vast amount of data of different goods cost should be collected and even then external factors such as taxes or market demands may explain a difference in the pricing of goods.
Additionally, economists use a “standard basket of goods” to measure a nation’s inflation (i.e. CPI). Each month the cost of the basket is calculated; compared to the previous month and inflation is inferred therefrom. It is an effective way to measure an individual nation’s inflation, however it becomes tricky to compare countries using the “basket” approach. A common flaw is that a typical basket of goods in the USA will vary greatly from the typical basket in China. One would be comparing apples to oranges – or French fries to noodles. To circumnavigate this issue, the Big Mac index was born. McDonald’s has outlets in 119 countries which sell identical Big Macs. The Big Mac index simply takes the average cost of a Big Mac in each country and allows us to see which countries’ Big Macs are relatively expensive or relatively cheap.
How does the index work?
The crux of the index is that it is essentially a Big Mac exchange rate. One can compare this exchange rate to the actual currency exchange rate. For example, suppose that a Big Mac costs $1 in the US and R20 in South Africa. The Big Mac exchange rate is $1:R20. Further, suppose the USD/ZAR exchange rate is $1:R15. Comparing the two, the Big Mac exchange suggests that the Rand is overvalued by R5 relative to the dollar.
Simply converting all the Big Mac prices into USD enables one to measure the PPP. Standardising the prices to US dollar unveils which countries are relatively expensive and which are relatively cheap.
How does SA measure?
According to a measure from January 2019, South Africa ranks as 4th cheapest on the index. For comparison, a Big Mac in Switzerland costs 3 times as much in dollar terms.
Currently, a Big Mac costs $3.99 in the US and R31 in South Africa. The Big Mac exchange is $3.99:R31, or $1:R7.77. However, the current USD/ZAR sits at $1:R14.60 – this suggests that US dollar is overvalued relative to the Rand! Overvalued by quite a lot. Will the currency market see a drastic reversal in favour of the Rand?
Almost certainly not. The Big Mac index, like nearly every other economic indicator has its flaws. The creation of the index most likely came about after a light-hearted discussion of bored scientists. The very implementation of the index is tongue-in-cheek. However, it may be humorous but it has its merits. At the very least, you can find comfort that your Big Mac indulgence is costing you 3 times less than in Switzerland!