Wednesday, March 23, 2005

Purchasing Power Parity in Big Macs

Yep, you read correctly. This is an index in the Economist magazine, which I saw quite a while ago, but dismissed it for some reason. Time to bring it back.

The index measures Purchasing Power Parity of different countries using Big Macs as the basket of goods. Purchasing power parity is the measure of relative purchasing power of different currencies.

The index table takes the price of a Big Mac as it is in United States as a base. The PPP of different countries is computed by taking a ratio of the price in, say Canadian Dollars in Toronto, to the price in US Dollars in New York.
Price of Big Mac in Toronto - 3.20
Price of Big Mac in New York - 2.65

PPP price = 1.22

Take the current exchange rate - 1.2093
Now compute the under/over valuation by taking the difference between the above PPP and the exchange rate and divide it by the exchange rate. Multiply it by 100 to get percentage!

U/O = [(1.22-1.2093)/1.2093]*100=.8848%
I.E. the canadian dollar is undervalued by .1151% agains the american dollar.

Now, don't go selling short you FX positions, because like everything else in the modern world, the PPP Big Mac index revolves around the US. ;)

For a most recent article about the Big Mac Index look here.

P.S. The prices of Big Macs in Toronto and New York were taken from the Economist data as of 2003, most likely it has changed since then. The exchange rate is of March 22, 2005.