Question

What is the main advantage of the Big Mac index to measure \purchasing power parity" (PPP)?

(Please be brief.)

Answer 1

Purchasing Power Parity (PPP)

PPP theory was developed by Gustav Cassel in early 1900s. It is an exchange rate theory that describes the relationship between the price level prevailed in a country and its exchange rate. The expected change in exchange rate equals the expected change in the inflation. This theory is based on Law of One Price. Law of One Price states that if a commodity (or product) or basket of products can be sold in two different markets, the price of the commodity or product must be same in both the markets. This is based on various assumptions. If the product has different prices in different markets, the arbitrage process will happen and the prices will become same.

Advantages of the Big Mac index

Big Mac Index was introduced by Economists in the year 1986. This index is based on PPP theory. It has the following advantages:

1. It publishes the index on undervaluation and overvaluation of currencies.
2. It shows which currency is correctly valued
3. Big Mac Index is useful in the countries where other reliable indices are not available.
4. Big Mac Index ensures easy comparison between inflation and exchange rate in various countries
5. The inflation data fro this index can be used for valuing financial instruments.
6. Big Mac Index as a tool can be used by the investors to analyse the international markets