Purchasing🌼 power parity (PPP) is the idea that the price of a good in one country should be the same as its price in another country after adjusting for the exchange rate between the two countries.

As a lighthearted annual test of PPP, the Economist has tracked the price of McDonald's Big Mac in many countries since 1986. Let's examine this indicator, known as the Big Mac PPP, and find out what the price of the ubiquitous Big Mac in a given country can tell us about international exchange rates.

Purchasing Power Parity: The Big Mac Index

The Big Mac Index is a survey created by the Economist that examines the relative over- or undervaluation of currencies based on the relative price of a Big Mac across the world. It uses the price of a McDonald's Big Mac burger as an informal way to measure the PPP between currencies. It's also based on the theory that the price of a good in one country is equal to its price in another country, after adjusting for the exchange rate between the two countries.

To illustrate how the Big Mac Index works, let's consider an example. In August 2023, a Big Mac cost $5.58 in the U.S. and £4.19 in the United Kingdom. The difference between the implied exchange rate of 0.75 and the actual exchange rate of 0.79 implied an undervaluation of the British pound by 3.8%. This means that the British pound was undervalued relative to the U.S. dollar, making U.S. goods relatively more expensive for British consumers and British goods relatively cheaper for U.S. consumers. However, by the end of the year, the undervaluation had fallen to 0.36%.

How Purchasing Power Parity (PPP) Works

Let's use another example. Suppose the U.S. dollar/Mexican peso exchange rate is 1/15 pesos. If the price of a Big Mac in the U.S. is $3, the price of a Big Mac in Mexico would be around 45 pesos—assuming the countries have purchasing power parity.

However, if the price of a Big Mac in Mexico were cl﷽oser to 75 pesos, Mexican fast-food shop owners could buy Big Macs in the U.S. for $3, for 45 pesos, and sell each in Mexico for 75 pesos, makin🤡g a 30-peso risk-free gain. (Although this is unlikely with hamburgers, the concept applies to other goods.)

To exploit this arbitrage, the demand for U.S. Big Macs would drive the U.S. Big Mac price up to $5, at which point the Mexican fast-food shop owners would have no risk-free gain. This is because it would cost them 75 pesos to buy U.S. Big Macs, which is the same price as in Mexico—thus restoring parity across the border. PPP also means parity among prices for the same good in all countries (the law of one price).

Currency Value

In the example above, where the Big Mac is for $3 and 45 pesos, a PPP exchange rate of $1 to 15 pesos is implied. The peso is overvalued against the U.S. dollar by 0% (as per the calculation: [15-15] ÷ 15), and the dollar is undervalued against the peso by 0% (as per the calculation: [0.0๊-0.0✤] ÷ 0.0).

In the 澳洲幸运5开奖号码历史查询:arbitrage opportunity above, the actions of many Mexica൲n fast-food shop owners selling pesos and buying dollars to exploit the price arbitrage would drive the peso's value down (depreciate) and the dollar up (appreciate). Of course, exploiting a Big Mac's prices alone is insufficient to drive a country's exchange rate up or down, but if applied to all goods—in theory—it might be enough to move a country's exchange rate so that price parity is restored.

For example, if the price of goods in Mexico is high relative to the same goods in the U.S., U.S. buyers would favor their domestic goods and shun Mexican goods. This loss of interest would eventually force Mexican sellers to lower 💦the price o🌳f their goods until they are at parity with U.S. goods.

Alternatively, the Mexican government could allow the peso to depreciate against the dollar, so U.S. buyers wouldn't have to pay more to buy their goods in Mexico.

Short-Term Versus Long-Term Parity

Empirical evidence has shown that PPP is not observed in the short term for many goods, and it's unclear if it applies in the澳洲幸运5开奖号码历史查询: long term. Federal Reserve economists Michael R. Pakko and Patricia S. Pollard gave their suggestions more than two decades ago about why PPP theory doesn't align with reality in a 2003 study, providing reasons that still stand up:

• Transport costs: Goods unavailable locally must be imported, resulting in transport costs. Imported goods will thus sell at a relatively higher price than the same goods available from local sources.
• Taxes: When governments charge sales taxes like the 澳洲幸运5开奖号码历史查询:value-added tax higher than in other countries, goods will be proportionally more costly.
• Government intervention: Import tariffs add to the price of imported goods. Where these are used to restrict supply, demand rises, causing the cost of the goods to rise. Its price will be lower in countries where the same good is unrestricted and abundant.
  
• Non-traded: The Big Mac's price is derived from input costs that are not traded. Therefore, those costs are unlikely to be at parity internationally. These costs can include the cost of premises, the cost of services such as insurance and utilities, and the cost of labor. According to PPP, in countries where non-traded costs are relatively high, goods will be relatively expensive, causing these countries' currencies to be overvalued relative to currencies in countries with lower non-traded costs.
• Market competition: Goods might be deliberately priced higher in a country because the company has a competitive advantage over other sellers, either because it has a monopoly or is part of a cartel of companies that manipulate prices.
• Inflation: The rate at which the price of goods (or baskets of goods) changes in countries—inflation—could indicate the value of those countries' currencies. Such 澳洲幸运5开奖号码历史查询:relative PPP overcomes the need for goods to be identical when examining the absolute PPP.

The Bottom Line

The Big Mac PPP is an informal measure of exchange rate valuation created by the Economist in 1986. It uses the price of a McDonald's Big Mac as a benchmark to compare the purchasing power between different currencies. The idea is based on the theory of purchasing power parity, which states that in the long term, exchange rates should move toward the rate that would equalize the prices of the same basket of goods and services in any two countries.

This relationship often doesn't hold in reality because of several confounding factors. However, over the long term, relative PPP has been seen to hold for some currencies when prices are adjusted for inflation.