The Big Mac Index was created by The Economist in 1986 to explain the theory of purchasing power parity. The idea behind the theory is that exchange rates of two currencies are considered to be “balanced” if they have the same purchasing power in their respective countries.
This means that if the SGD is in equilibrium with the Malaysian Ringgit and an item costs SGD$1 in Singapore, the same identical item should cost RM3, given an exchange rate of 1:3.
Why A Big Mac?
For the index to be fair (or as accurate as possible), the item used should be one that can be found in every part of the world. In 1986, when the Big Mac Index was born, McDonalds represented globalisation. This resulted in the Big Mac being used as a basis of comparison.
How Does It Work?
Let’s use the example of the SGD and the MYR. To find out if the SGD is overvalued or undervalued against the MYR, the following formula is used:
If the value is negative, then the SGD is overvalued. Similarly, if the value is positive, the SGD is undervalued. Let’s use real numbers now.
So the SGD is overvalued against the MYR by 104%! On the other hand, the MYR is undervalued against the SGD by about 50%.
From the Big Mac Index, we can find out how the SGD is faring against other currencies too. This also means that your next travel destination can be decided by the index. The more undervalued a currency is against the SGD, the cheaper your travel expenses will be!
But The Big Mac Index Is Far From Perfect
Firstly, McDonalds is still not present in many countries like Nepal and Iceland. However, many new informal indexes such as the iPhone Index and the Starbucks Index have attempted to solve this issue.
Next, the Big Mac burger is not entirely identical in every country – in India, the patty is not made of beef. This also means that the cost of production, wages, and rental vary in different countries, hence it may not be a fair comparison.
Also, due to price stickiness, the prices of Big Macs will not change just because a currency appreciates or depreciates. This is because of the costs that come with changing of prices, and the fact that changing prices may cause them to lose customers and profits.
All in all, the Big Mac Index is just a fun way for us to understand how Purchasing Power Parity works. In reality, such analysis is much more complex and requires the consideration of more factors.
Read Also: Why You Pay More For Magnum Ice Cream Sticks In Singapore
Top Image Credit: DollarsAndSense.sg
