Question

the big mac index is considered a good candidate for the application of the law of one price and measurement of under or overvaluation of a currency. develop on five argument as to why this is a good idea.

Answer 1

Some of the arguments that can be given in favour of the BIg Mac index is that:

1. In the traditional method of calculating the Purchasing Power Parity, the exchange rates should adjust in such a manner that the basket of goods should cost the same among different countries. For this the basket of goods should have similar commodities. But this is not practically possible as a basket of commoditity may comprise of different goods which may vary with countries. This gives Big Mac index more credibility over the traditional index. Since Big Mac is sold in many countries and contain similar ingrediants, the cost comparision makes it more viable to compare across countries.

2. Its relatively easy to compute as compared to the traditional Purchasing Power parity method. In the Big Mac index, the prices of Big Mac sold in two countries are compared. The Big mac PPP is obtained by directly dividing the Price of the Big mac sold in one country with the price of Big mac sold in other country in their respective currencies. It is then compared to the ongoing exchange rate of the currencies of both the countries. If the value of the BIg Mac PPP is found to be lower than the exchange rate, the first currency is undervalued as compared to the second and if the Big Mac PPP is higher than the exchange rate, the value of the first currency is overvalued as compared to the second.

3. The Big Mac index has resulted in formation of several new similar varients, which are either similar to or an improvement over the Big Mac index. Some of the Varients are : Gold mac Index, Tall Latte Index, Billy index, i pod index. Some of these varients have been an improved version of the BIg Mac index and hence presents as viable alternatives over the traditional index.

4. The Big Mac index is chosen on the basis that Mc Donald franchises present in most of the countries commonly sells the Big Mac burger in all such countries and the Mc Donanld's franchisies have responsibilities of negotiating the input prices and is representative of local prices of raw materials. This enables the comparision of currencies in various countries.

5. The Big Mac index has been pretty reliable so far. Since its inception it has maintained a good track record of predicting the direction of currencies. It has also proven to be relatively useful for those countries where relaible indexes are not availble, such as in the countries where official data is tampered, or manipulated or those where official data is not published. This proves to be problematic for the investors to compare the consumer inflation with the exchange rates. Big Mac index becomes handy in such casses.

5.