Friday, October 1, 2010

How good is the Big Mac index?

The Big Mac index, created in 1986 by the Economist to estimate the over- or under-evaluation of currencies, is based on the price comparison of a uniform good across countries. In the best case, purchasing power parity would hold, and it typically does not. But the choice of McDonald's Big Mac always struck me as poor for such an exercise. Its major ingredient, meat, is subject to regulation and subsidies that vary considerably across countries, including trade barriers. And a major part of its price is the "service" which is offered by the restaurant, which is non-tradable. In short, it would even be a surprise were purchasing power parity to hold.

Kenneth Clements, Yihui Lan and Shi Pei Seah have looked at this more formally than I just did. They find that the Big Mac index indeed suffers from biases, and thus its predictions are biased. But they can be corrected. The index even beats the best predictor of exchange rates, at least at medium to long range, the random walk. This should not surprise us, however. After all, if there are strong deviations from purchasing power parity, they should correct themselves in the long run.

I prefer the iPod index that the Commonwealth Bank of Australia computes periodically. iPods are traded, identical (once you choose which one to index), and widely available. Only drawback: Apple has the ability to price to market thanks to its market power. I am waiting for someone to use it to see whether it beat the Big Mac index.

1 comment:

vivaeastafrica said...

by vivaeastafrica
I just returned from a two-week visit to Egypt and as an economist did collect data on prices and wages to do up a poverty profile of the country. Like you I always thought the choice of the Big Mac as a predictor of exchange rates was bogus. For Egypt it shows the currency is undervalued - the Big Mac is cheaper in Cairo than the composite one in the USA. Why should it not?! The supervisour(sic; that way spelt on the ID badge)'s daily salary would purchase just 2 Big Macs, compared to 2 from an ordinary worker's hourly wage in the US. I stuck to falafel - the same number of calories as the Big Mac at one-tenth the price and twice the taste. Will write to the Economist.