If markets are functioning properly the same good should have the same price even if it is in different locations. This is known as “the law of one price” and rests on the assumption that arbitrage will eliminate any price differentials. This simple claim is the basis of the purchasing power parity (PPP) theory of exchange rate determination. PPP implies that over time exchange rates should adjust to ensure that the price of a basket of identical goods costs the same in different countries. If – having taken the market exchange rate – a basket of goods is cheaper in one country than another, it suggests that the currency may be undervalued. Generally speaking, economists think that in the long run foreign currency will be determined by PPP.
Since 1986 The Economist magazine has promoted a light-hearted application of PPP by using a single good in its basket: a Big Mac.
In June 2012 a Big Mac cost $4.20 in America, but – at market exchange rates – it cost $6.81 in Switzerland and only $2.44 in China. In theory it should cost the same. The fact that it is more expensive in Switzerland implies the Swiss franc may be overvalued relative to the dollar. And the fact it’s cheaper in China is evidence that the yuan may be undervalued. All else being equal, we would expect the Swiss franc to depreciate relative to the dollar, and the Chinese yuan to appreciate, until their respective purchas-ing powers were the same. There are several reasons why a Big Mac is a suitable good to use:
Of course there are some downsides too
This suggests that the Big Mac index may be more useful when comparing countries at a similar level of economic development, but in reality it should not be useful at all. The fact that it has demonstrated better predictive power than a number of highly complex indices that incorporate a large basket of multiple goods simply demonstrates the difficulty of predicting foreign exchange movements.
As of January 2023 the GBP appeared undervalued:
For more on the Big Mac Index, see here: https://www.economist.com/big-mac-index