Econ 101 – Big Mac Economics

Currencies are fickle, moving up and down against one another seemingly at will. Economists have several theories of how relative currency values are determined. One of these is the purchasing power parity hypothesis.

In a frictionless world (only economists invent such worlds and terms), identical goods would sell for identical prices. In the real world, frictions like transportation, taxes, other transactions costs, government interventions, etc. produce differences.

One of the methods of ascertaining the whether currencies are over or undervalued in terms of the purchasing power hypothesis is to look at the cost of a common good around the world. Convert all currencies into a common currency (in the case below, the dollar) and then compare the prices of a universally available good or commodity. Because McDonalds is almost everywhere in the world, they provides one means of comparison. The graph below compares the equivalent dollar cost of a Big Mac in several countries:

According to economists, in a perfect world (“perfect” is another common term of economists), Big Macs would cost the same around the world. Of course the world is not perfect. Nor is the above test.  While the test is easy and entertaining, it is not particularly rigorous.

According to the purchasing power theory, one might claim that countries paying more than the US for a Big Mac have currencies overvalued in terms of the dollar.  Those paying less have currencies undervalued relative to the dollar.

That is your tongue- (or hamburger) in-cheek lesson for today. Do not make investment decisions based on this simple example. More generally, try not to base investment decisions on economist’s opinions or predictions.

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