Question

10. a. (2) What is the Big Mac Index? b.(3) Suppose the price of a Big Mac in the EU is 4.5 € and the price of a Big Mac in the US is $3.25. What is the implied exchange rate? Explain how you calculated the rate. c. (3) Suppose the actual exchange rate is $1=1€. According to the Big Mac Index, is the euro overvalued or undervalued. d. (3) If you are a currency investor who has confidence in the Big Mac Index, should you buy dollars or euros? Explain. e. (3) What are some limitations of the Big Mac index?

Answer 1

Answer)

1. Big Mac Index is the way of measuring purchasing power parity,a burger Big Mac is used a single good and is compared with prices in different countries,now a currency is overvalued or undervalued is found out by comparing Big Mac index with actual exchange rate.It was introduced in 1986 and is aimed at creating a simple way to see purchasing power parity.
2. Implied exchange rate=Price of Big Mac in EU/Price of Big Mac in US=4.5/3.25=1.38,we calculated the rate by formula;Implied exchange ratePrice of Big Mac in country 1/Price of Big Mac in country 2
3. Since actual exchange rate is $1=1€,however in Big Mac index it costs more in Euro terms ,so Euro is overvalued as it would have been fairly valued if Big Mac exchange rate would have been 1 or in other words it would have cost 3.25€ to buy 1 burger,so Euro is overvalued by 38%{[(4.5-3.25)/3.25]*100}
4. As explained above since Euro is overvalued,I would buy Dollars expecting it to appreciate in value and reach its true value.
5. Limitations of Big Mac index is that this burger is not present in some countries,there could be government policies such as protectionism which could have raised prices,creating distortions,there could be varying demand in different countries which again could distort the index.

Answer is complete.Thank you!