A relatively fixed set of consumer products and services valued and used on an annual basis to track inflation in a specific market or country. The goods in the basket are often adjusted periodically to account for changes in consumer habits The basket of goods is used primarily to calculate the Consumer Price Index (CPI).

Purchasing power parity (PPP) is a theory of long-term equilibrium exchange rates based on relative price levels of two countries. The idea originated with the School of Salamanca in the 16th century [1] and was developed in its modern form by Gustav Cassel in 1918.[2] The concept is founded on the law of one price; the idea that in absence of transaction costs, identical goods will have the same price in different markets.

Implied PPP of the Dollar = Big Mac Price in Local Currency / Big Mac Price in Dollars

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You can think of implied PPP like this. If a Big Mac costs 11.5 Pesos in Argentina and the same Big Mac costs $3.57 in the United States, then according to Purchasing Power Parity (and using the Big Mac as a typical basket of goods) 11.5 Pesos should equal $3.57. If 11.5 Argentinian Pesos did in fact equal $3.57 then the exchange rate would be 11.5 / 3.57 = 3.22 Pesos per dollar. So in this case, the Implied PPP of the Dollar is 3.22 Argentinian Pesos.

Likewise, in Brazil a Big Mac costs 8.03 Brazilian Reals and again in the United States it costs $3.57, then the Implied PPP of the Dollar would be 8.03 / 3.57 = 2.25 Reals per Dollar. Since you can actually buy 2 Reals per dollar (according to this Big Mac Index report) this implies that the currency is overvalued by 13%. Click here for more information of the relative over or undervaluation of currencies as used in the Big Mac Index.

Please post any questions you have as a comment to this post. Thanks.

Besides being an excellent investing tool, the Big Mac Index can be used to calculate changes in real income. In Big Mac terms, real income is basically the amount of Big Macs you can buy. You can also think of real income as purchasing power.

Real Income = Nominal Income / Price Level

Since Price Level is related to inflation, you can think of real income as “the income of nations or individuals after adjusting for inflation”. Business Insider did a story about the purchasing power of $100,000 in 20 cities worldwide. The thing is though, they used the price of a Big Mac as the price level (or cost of living) in their calculations. For calculations relating to price levels or costs of living, a “basket of goods” is usually used. This time though, it’s the good old Big Mac Index. Here are the results …



These are the dates that the Big Mac Index was published in the The Economist print edition.

What is a tradable good?

A tradable good is a good that can easily be sold in a location other than where it was produced. Tradable and non-tradable goods do not fall into two distinct categories but rather they fall on a continuum with some goods being perfectly tradable (like a share of stock or currency), some being perfectly untradable (like a haircut), and most other goods falling somewhere in the middle. Prepared food is not usually considered a tradable good because it’s hard to transport.

What factors contribute to a good’s “tradability” or lack of “tradability”?

Goods that have long shelf lives, and less transportation costs are typically thought of as tradable. Likewise, goods that perish quickly or are cumbersome or very expensive to transport fall on the “non-tradable” end of the spectrum.

What does this have to do with the Big Mac Index?

Non-tradable goods are less subject to the “law of one price” than tradable goods. Another way of saying that is that Purchasing Power Parity does not necessarily hold for non-tradable goods since the opportunity for arbitrage are less. For PPP (and the law of one price) to hold, there must be an effecient market like the foreign exhange market or a stock market. This doesn’t mean that the Big Mac Index is an ineffective measure of PPP or the value of currencies. It simply means that the Big Mac Index, like any other measure of economic comparison is subject to limitations and should be thought of as such.

This excerpt is from The Economist and describes the long term tendency of currency values to converge. In other words, move toward a situation where a dollar has the same purchasing power no matter what country you’re in.

Burgernomics is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. Thus in the long run, the exchange rate between two countries should move towards the rate that equalises the prices of an identical basket of goods and services in each country. Our “basket” is a McDonald’s Big Mac, which is produced in about 120 countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued.

The Economist uses the price of the ubiquitous McDonald’s meal to calculate the “Big Mac Index”, a guide showing how far from fair value different world currencies are. The Big Mac theory (a.k.a. purchasing-power parity, or PPP) says that exchange rates should even out the prices of Big Macs sold across the world.

The implied PPP shown in the table is the exchange rate that would make a Big Mac cost the same abroad as it does in the USA. When you compare actual exchange rates with the implied PPP rate, you will see that most currencies are trading way above or below the US dollar, meaning that they are over- or undervalued. Keep in mind that PPP is a long-term indicator, pointing to where currencies ought to go in the future. (It’s also best to use it only to measure currencies between countries that are at a similar stage of developmen