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1. What is purchasing power parity? 2. Why is a McDonald's Big Mac used to create the index? 3. What are the limitations of the Big Mac Index?

1. What is purchasing power parity? 2. Why is a McDonald's Big Mac used to create the index? 3. What are the limitations of the Big Mac Index?

ENGR.ECONOMIC ANALYSIS
ENGR.ECONOMIC ANALYSIS
14th Edition
ISBN:9780190931919
Author:NEWNAN
Publisher:NEWNAN
Chapter1: Making Economics Decisions
Section: Chapter Questions
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See for Yourself Case Taking a Bite Out of Purchasing Power Parity with the Big Mac Index In 1986, Pam Woodall introduced the Big Mac Index as an illustration of purchasing power parity (PPP), which is the theory that currencies will go up or down in value to keep their purchasing power consistent across countries. Initially a lighthearted guide to whether currencies are at their "correct" level, the Big Mac Index has grown into a global standard and is now featured in many economic textbooks and dozens of academic studies. Many refer to this as "Burgernomics." The Big Mac Index is based on the theory of PPP that says, in the long run, exchange rates should move toward the rate that would equalize the prices of an identical basket of goods and services in any two countries. This means that the price of an item in one currency should be the same price in any other currency, adjusted for that currency's exchange rate. The Big Mac Index was never intended as a precise gauge of currency misalignment but rather a tool to make the theory surrounding exchange rates easier to understand. McDonald's was chosen because it is sold in 140 countries and is familiar to those trying to understand PPP. Twice a year, The Economist sends out people to purchase Big Macs all over the world. They then convert the prices paid in each country into Page 505 dollars, and the index can show whether the currency is under- or overvalued. For example, if the United States and Mexico have PPP, then a Big Mac that is $3 in the United States would be roughly 55 pesos in Mexico. However, if the price in Mexico is higher, it would mean the peso is overvalued and Mexico has more purchasing power than the United States. Or, if the Big Mac in Mexico was priced lower, then the peso would be undervalued and Mexico would have less purchasing power than the United States. The index concept has been used with Apple's iPad mini and IKEA's BILLY bookcase. Users of the Big Mac Index should be wary of the limitations of PPP. Issues include the idea that the price of a Big Mac will be dependent on local production, transportation costs, and promotion costs and that there may be price variation based on geographic location (e.g., city versus rural area). Other issues not taken into account in the PPP include government intervention (taxes and tariffs), market competition (monopolies), and inflation. It has been said that the GDP-adjusted index better addresses the issues that affect the PPP and may be a better guide to the current fair value of a currency. Despite its limitations, the PPP still serves its purpose every year by providing a quick and easy measure of currency values. Users should not rely too heavily on its calculations and should always investigate further.14 Critical Thinking Questions 1. What is purchasing power parity? 2. Why is a McDonald's Big Mac used to create the index? 3. What are the limitations of the Big Mac Index? ŷ
Transcribed Image Text:See for Yourself Case Taking a Bite Out of Purchasing Power Parity with the Big Mac Index In 1986, Pam Woodall introduced the Big Mac Index as an illustration of purchasing power parity (PPP), which is the theory that currencies will go up or down in value to keep their purchasing power consistent across countries. Initially a lighthearted guide to whether currencies are at their "correct" level, the Big Mac Index has grown into a global standard and is now featured in many economic textbooks and dozens of academic studies. Many refer to this as "Burgernomics." The Big Mac Index is based on the theory of PPP that says, in the long run, exchange rates should move toward the rate that would equalize the prices of an identical basket of goods and services in any two countries. This means that the price of an item in one currency should be the same price in any other currency, adjusted for that currency's exchange rate. The Big Mac Index was never intended as a precise gauge of currency misalignment but rather a tool to make the theory surrounding exchange rates easier to understand. McDonald's was chosen because it is sold in 140 countries and is familiar to those trying to understand PPP. Twice a year, The Economist sends out people to purchase Big Macs all over the world. They then convert the prices paid in each country into Page 505 dollars, and the index can show whether the currency is under- or overvalued. For example, if the United States and Mexico have PPP, then a Big Mac that is $3 in the United States would be roughly 55 pesos in Mexico. However, if the price in Mexico is higher, it would mean the peso is overvalued and Mexico has more purchasing power than the United States. Or, if the Big Mac in Mexico was priced lower, then the peso would be undervalued and Mexico would have less purchasing power than the United States. The index concept has been used with Apple's iPad mini and IKEA's BILLY bookcase. Users of the Big Mac Index should be wary of the limitations of PPP. Issues include the idea that the price of a Big Mac will be dependent on local production, transportation costs, and promotion costs and that there may be price variation based on geographic location (e.g., city versus rural area). Other issues not taken into account in the PPP include government intervention (taxes and tariffs), market competition (monopolies), and inflation. It has been said that the GDP-adjusted index better addresses the issues that affect the PPP and may be a better guide to the current fair value of a currency. Despite its limitations, the PPP still serves its purpose every year by providing a quick and easy measure of currency values. Users should not rely too heavily on its calculations and should always investigate further.14 Critical Thinking Questions 1. What is purchasing power parity? 2. Why is a McDonald's Big Mac used to create the index? 3. What are the limitations of the Big Mac Index? ŷ
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