Question

Suppose a US investor wants to invest in the foreign exchange market by buying a foreign currency today and selling it in a year. The following information is available to him:

Country	Price of big mac (local currency)	Elocal/$
United States	4	1
Japan	380	100
Mexico	50	10

In dollars, how much does a big mac cost in Japan and in Mexico? Show your work.

Explain the concept of the Big Mac Index. Which currency is over-valued? Which is under-valued?

Answer 1

The Big Mac Index is calculated and published by The Economist as a way of measuring the purchasing power parity (PPP) between two currencies through a comparison of the price of the Big Mac in both countries. It can thus test of the extent to which market exchange rates result in goods costing the same in different countries.

Value of 1 dollar viz-a-viz Japanese currency = 100 units of the Japanese currency

Cost of Big Mac in Japanese currency = 380

Thus cost in USD = 380/100 = $3.8

Value of 1 dollar viz-a-viz Mexican currency = 10 units of the Mexican currency

Cost of Big Mac in Mexican currency = 50

Thus cost in USD = 50/10 = $5

Now, this means that the purchasing power parity in for Japan and US is 380/4 = 95 i.e. the value of 1 dollar in purchasing power terms should be 95 Japanese currency units, but since the actual rate is 100 units, the Japanese currency is undervalued.

Now, this means that the purchasing power parity in for Mexico and US is 50/4 = 12.5 i.e. the value of 1 dollar in purchasing power terms should be 12.5 Mexican currency units, but since the actual rate is 10 units, the Mexican currency is overvalued.