Tuesday, 2 August 2011

The Big Max Index Gets Beefed Up

The Economist's Big Max Index, long a topic of discussion in many of the courses that I teach has been given an upgrade. In its original form, the Big Max Index compares the prices of Big Macs around the world. The relative price of Big Macs in two countries gives an approximate value of purchasing power parity (PPP). The currency exchange rate between two countries can be compared to this PPP value to get a sense of whether currencies are over or under valued. PPP is a long run concept and is used to determine what exchange rates should be in the long run. PPP, however, is less useful for determining whether current exchange rates are over or under valued. The Big Max itself is not a traded basked of goods, but one could argue that the components of a Big Mac are traded.

The Economist has released a new and improved trade weighted Big Max Index that takes into account GDP per capita. This new index should be better suited for comparing exchange rate valuations in the short term because this index takes into account price differences between countries. On average, prices are cheaper in poor countries. The different versions of the Big  Max Index do give different results for some countries. The differences are large for the BRIC countries. In the case of China, for example, the raw index indicates that the yuan is significantly undervalued while the new index indicates the yuan is close to fair value. For Canada, there is not much difference between the two calculations.

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