Not everyone finds macroeconomics as riveting a subject as we do here at Nomad Capitalist, but thanks to the Economist Magazine’s Big Mac Index, concepts like Purchasing Power Parity (PPP) and the Law of One Price are more interesting and accessible than ever before.

1986 was an exciting year in the financial and economic world: Microsoft had its initial public offering, the British Government deregulated its markets in what became known as the “Big Bang,” and “Burgernomics” was born.

Since then, the Big Mac Index has been used by the Economist Magazine to determine and track a currency’s over- or undervaluation by comparing the different prices we pay for the iconic Big Mac burger in various countries around the world.

The Theory Explained

At its most basic, the Big Mac Index is a way to gauge a currency’s over- or undervaluation using the Law of One Price, Purchase Power Parity, and the cost of the iconic Big Mac.

The Law of One Price

The Big Mac Index is an example of how we measure the law of one price, which states that in the absence of any transport costs and trade tariffs and if free competition and price flexibility are present, then identical goods will cost the same price regardless of where you purchase them (once converted into a common currency).

This seems pretty straightforward since you would expect to pay the same amount for an ounce of gold in Australia as you would in Zambia. However, I also know that a pint of beer in Geneva is going to cost me way more than a beer in Warsaw.

Therefore, it seems that this may generally be true for commodities such as gold, but it doesn’t always apply to other goods. In theory, however, even when prices are not currently the same across borders, over time they should move towards the same price.

This follows from the assumption upon which the law of one price is based – any variations in pricing that exist between two separate locations will inevitably be eradicated once enough participants in the market begin to exploit arbitrage opportunities that exist.

Our regular readers might be familiar with the concept of geoarbitrage, a topic Andrew has written extensively on. Geoarbitrage is based on the same concept as arbitrage, but it focuses on the disparities in labor costs between countries, noting how exploiting these disparities will deliver a greater return on your time. For instance, if you wish to hire an online personal assistant, then you can save money by hiring someone from Eastern Europe since their wage requirements will be lower than someone from the US.

However, the arbitrage I am discussing here is slightly different, and it is generally applied to financial instruments. This type of arbitrage refers to any transaction that exploits pricing imbalances that exist for a tradable item between two or more markets. such as if you were able to buy a financial instrument in one market and sell it in another for a risk-free profit.

This arbitrage actually operates as an instrument that regulates pricing across markets because once the pricing imbalance is noticed by either or both markets, the pricing will likely be adjusted to eliminate the discrepancy.

The Big Mac Index applies to the Law of One price to the hamburger business.

Now, Big Mac burgers are not really all that susceptible to the practice of arbitrage, but they can provide a tasty example of how the concept works.

Here is a hypothetical scenario based on the figures released in the 2019 Big Mac Index to illustrate the concept:

A Big Mac costs $4.46 (R$ 16.9) in Brazil while it costs just $3.18 (S 10.5) across the border in Peru.

So, a McDonald’s restaurant that is situated on the Brazilian side of the border could potentially purchase all of its Big Macs from a McDonald’s situated on the Peruvian side of the border for $3.18

Then, it could go on to sell those Big Macs to its Brazilian customers for $4.46, providing a risk-free profit of $1.28 a burger – until, of course, this behavior causes the prices to converge either by adjustments in the prices themselves, adjustments in the value of the currency, or both, resulting in purchasing power parity.

Purchase Power Parity (PPP)

So, what is purchase power parity? Well, as the above example implies, it is an economic theory that is founded on the law of one price.

To offer a somewhat superficial account, PPP provides that the exchange rate between two countries should be equal to the ratio of the respective purchasing power of those currencies. If this is not the case, then one of the currencies may be either over- or undervalued against the other currency.

Customarily, a “basket of goods” is used to determine purchasing power, but the burger-loving folks over at the Economist simplified things by placing just a single Big Mac burger in their hypothetical basket, making the concept a bit easier to digest.

Here is how the Economist Magazine applies this concept in their Big Mac index:

The cost for a Big Mac in Britain in 2018 was £3.19, or $4.41 if converted using the exchange rate of 0.72. In the United States, the same Big Mac cost $5.28.

We can attain an implied exchange rate, or PPP, by dividing the cost of the Big Mac in Britain (using the value in pounds sterling) by the price charged in the US (in USD).

So, 3.19 divided by 5.28 provides us with an implied exchange rate of 0.6.

To calculate to what extent one currency is over- or undervalued against another, you take the difference between the implied exchange rate and the actual exchange rate and then divide by the actual exchange rate.

In this case, 0.6 minus 0.72 gives us -0.12, and if you divide that by 0.72, we can conclude that the British pound is undervalued by around 16%.

Ronald McDonald and Macroeconomics

“Why a Big Mac?” you may ask. I know I did at first. Well, although basing a macroeconomic analysis on a single fast food item might seem counter-intuitive and arbitrary, it actually makes a lot of sense.

For starters, McDonald’s has a phenomenally wide reach in the international community, where it serves close to 70 million people a day in over 120 countries. The meteoric rise of this American burger institution is a truly astonishing story, and Forbes Magazine’s Global 2000 Ranking for 2018 showing McDonald’s once again retaining pole position as the largest restaurant chain in the world by revenue.

Another factor that makes the Big Mac a great candidate for this metric is that it is mostly produced to the same specifications throughout the world, which means – in theory at least – that the costs of producing the burger should be relatively standard across the globe.

Since the input costs involved in producing the Big Mac are located in several various sectors of the local economy – such as advertising, agriculture, transport, and labor – it could be argued that the burger is a lot closer to a “basket of goods” than it appears.

Although economists usually use a basket of goods to determine purchasing power, a burger comes surprisingly close.

However, the index is not without its critics. In 2016, Andrew wrote an article on the Big Mac Index where he explained the theory behind the index and highlighted potential insights around financial trends that it could provide.

Andrew also touched on several factors that were not taken into consideration when calculating the Big Mac Index that could have caused potential inaccuracies. Here are a few of the more glaring limitations that exist in the methodology of the Big Mac Index:

First, the index has no way of incorporating considerations like the impact of taxation, local competition levels, or even the social status that is attached to dining at a fast food chain in a particular society.

Second, the popularity of the Big Mac will vary from location to location. As a result, McDonald’s may respond to this demand by pursuing a high-volume, low-margin strategy in locations where the Big Mac is popular, but in locations with fewer Big Mac orders, they may seek to generate more profit through higher margins.

Finally, while the reach of the Big Mac is astounding, there are some notable gaps in its availability in certain regions, particularly Africa. Only three of the fifty-four African countries currently bask in the illuminating glow of the golden arches – South Africa, Egypt, and Morocco. Africa is home to around 16% of the world’s population, which means that many of them remain unrepresented by the Big Mac Index.

The Adjusted Version

In 2011, the Economist decided to address one shortfall in their Big Mac Index by offering an alternative index that has been adjusted to account for GDP per capita when assessing the fair value of a currency.

Keeping in line with their culinary theme, they refer to this adjusted version of their raw index as the “gourmet version.”

Using a statistical tool called the line of best fit between GDP per capita and the price of a Big Mac, the Economist provides a more realistic view of a currency’s current fair value.

How to Use the Big Mac Index to Guide your Investments

The Big Mac Index can provide you with some fantastic insight into how various currencies may react in the future. However, just like any other investment strategy, it is important to practice the right amount of due diligence before acting.

In this section, we’ll undertake a superficial analysis of how the Big Mac Index has the potential to inform foreign exchange investments. As you read, keep in mind that this analysis is meant to get you thinking – it’s not professional investment advice.

Below, I have analyzed the accuracy of the Big Mac Index using the figures released in 2011 and 2018 for seven countries that I selected at random.

In this analysis, I use both the raw Big Mac Index and the “gourmet” Big Mac Index that takes GDP per capita into account.

Now, if you were operating a currency hedge fund, applying the principle of selling overvalued currencies (expecting their values against the dollar to decrease) and buying those that are undervalued (expecting their values against the dollar to strengthen), you might have made a few bad calls.

Working off the raw index, you might have been tempted to purchase the currencies of South Africa (undervalued by 29.3%), Egypt (undervalued by 41.9%), and India (undervalued by 53.5%), and you most likely would have ignored Britain’s undervaluation of around 4% and sold off the currencies of Switzerland (overvalued by 98.4%), Brazil (overvalued by 51.9%), and the Euro Zone (overvalued by 21.2%).

However, when looking at the three countries that were significantly undervalued against the dollar in 2011, you’ll notice that they depreciated further by 2018. The South African rand, for instance, is rapidly declining, and political instability in Egypt has continued to depress its currency value.

Interestingly, India – despite the exchange rate slipping from 44.4 to 63.89 – actually reduced its margin of undervaluation from 53.5% to 46.6%. Upon closer inspection, however, you will notice that this is in fact due to a sharp spike in the Indian price of the Big Mac – the beloved burger cost 80% more in 2016 than it did in 2013.

The currencies in the table that you would have potentially sold off – Switzerland. Brazil, and the Euro Zone – did, in fact, depreciate against the dollar.

While you could technically use the Big Mac Index to guide your investments, it isn’t always on the ball.

On the other hand, if you were working with the adjusted index, you would have been more likely to sell all currencies except that of India.

When examining the two indices, the first thing you are likely to notice is the remarkable difference between the raw index and adjusted index in relation to the over or undervaluation of currencies against the dollar.

The adjusted index also seems more reliable in predicting fluctuations in exchange rates. In this brief analysis, six out of the seven countries behaved as predicted by the adjusted index in 2011 as opposed to just three in the raw index.

Of course, this is a very small sample group of countries, and as is the case with statistics, they can often represent a myriad of contrasting phenomena depending on how, and by whom, they are used.

Based on the figures above, it certainly appears that the adjusted index is a more accurate account of a currency’s over- or undervaluation against another currency. Therefore, if you were to use the Big Mac Index to guide your trading decisions, the adjusted index is the safer bet.

Big Mac Prices around the world

At this point, you might be wondering which countries are the most expensive to buy a Big Mac in and which countries are the cheapest.

Below is a list of five countries where you will pay the most for a Big Mac and the five countries where you will pay the least.

Although the Big Mac Index isn’t an exact science, it can provide a rough indication of living costs from country to country, but as we have seen, there are a myriad of other factors involved that you need to consider when applying the results of the Big Mac Index.

The Five Most Expensive Countries

These are the most expensive countries to buy a Big Mac in based on 2018 figures.

SWITZERLAND: $6.76 (6.50 CHF)

Actual exchange rate = 0.96

Implied exchange rate = 1.23

Zurich, which is often cited as the world’s most expensive city, is also fittingly home to the world’s most expensive Big Mac.

According to the Big Mac Index, the Swiss franc is overvalued by 28.1%. If we look at the adjusted index, however, you will notice that that figure is much lower, showing the franc being just 8.1% overvalued. However, it is still considered the 11th most overvalued currency in the world.

To illustrate just how expensive this beloved burger is in Switzerland, for the price of one Big Mac in Switzerland, you could feast on four of them in Ukraine.

Factors that contribute to higher costs in producing the burger in Switzerland include relatively high wages and a heavy tax on imported goods imposed to shield and support local Swiss farmers.

NORWAY $6.24 (49 NOK)

Actual exchange rate = 8.02

Implied exchange rate = 9.28

Norway is home to the second most expensive Big Mac burger in the world with a price tag of $6.24, which is the equivalent of 49 Krone.

Oslo is the most expensive city in the world in which to enjoy a pint of beer, and with the 2nd most expensive Big Mac, it looks as if a night out drinking and feasting on fast food may be quite a pricey affair.

This is partially thanks to Norway’s high wages and high cost of living. According to Deutsche Bank, Oslo, Norway had the 8th highest average salary in the world in 2017, and higher wages combined with tolls placed on imported produce keep restaurant prices high.

According to the Big Mac Raw Index, the krone is overvalued by 18.2% while the Adjusted index reveals that the krone is overvalued by 22.4%.

SWEDEN $6.12 (49.10 SEK)

Actual exchange rate = 8.02

Implied exchange rate = 9.30

Sweden has the world’s third most expensive Big Mac at $6.12, making it the most expensive in the European Union. Sweden has fallen slightly in the Big Mac Index, dropping down from the second-place seat it occupied in 2017.

If you think a Big Mac in Sweden will flatten your wallet, wait until you hear about their tax rates. Sweden imposes some seriously steep taxes – the highest in the world – with top-tier earners facing ferocious taxation of up to 60%.

The cost of a Swedish Big Mac is quite high, and so are the country’s taxes.

Despite these high tax rates, the Swedish economy has been steadily growing and flourishing for the past few decades, and citizens enjoy the “cradle to grave” welfare system. However, this system’s sustainability has been questioned more recently as Swedish citizens become more concerned with the quality of welfare they receive considering the amount of tax they pay.

The hefty price of a Swedish Big Mac is attributed to higher taxes, higher wages, and a willingness and ability to pay higher prices among Swedish consumers.

According to the Big Mac Index, the Swedish Krona is overvalued by 16%. The adjusted index has it more overvalued at 22.4%

UNITED STATES $5.28

The strength of the dollar means that you will pay less for the iconic American Sandwich almost anywhere else in the world, making it a good time to travel with the greenback in your pocket.

U.S food prices are naturally affected by the strength of the dollar. When the dollar is strong, exports of food for sale in overseas markets generally drop, which produces supply in the local market and effectively drives food prices down.

Another reason why the US Big Mac is comparatively more expensive is that this price is an average of all Big Mac prices in the US. There are significant fluctuations in the cost of living among states and cities, so Big Macs in expensive regions like New York City or the California Bay Area are naturally going to drive up the average.

CANADA $5.26 (C$6.55)

Actual Exchange Rate = 1.25

Implied Exchange Rate = 1.24

Canada has seen sharp increase in price from last year’s Big Mac Index, where the cost was listed at $4.60 – $0.44 less than the US price.

Canada is one of the few developed nations that actually exports net energy and boasts a 13% share of the world’s oil reserves.

The Canadian economy is heavily dominated by the service industry, and Canadian salaries are among the highest in the world with a minimum wage the equivalent of $8.20 an hour and two of its cities – Vancouver and Toronto – are among the top 28 cities where workers have the highest wages on the Deutsche Bank’s “Mapping the World’s Prices” annual report.

Canada has the 10th highest ranking in the Human Development Index and the 15th highest nominal per capita income in the world, and thanks to the country’s natural resources, the Canadian dollar is one of the world’s most stable and robust currencies.

The good trade relationship between Canada and the US, however, has declined recently due to disagreements between Trump and Trudeau. Trump has vowed to alter the North American Free Trade Agreement of 1994 (NAFTA), which will likely impact food prices and might mean a more expensive Big Mac in future.

According to the Big Mac Index, the Canadian dollar was undervalued by a negligible .04%. However, the adjusted index shows it to actually be overvalued against the US dollar by 13.8%.

The Five Cheapest Countries

On the other hand, here are the five countries with the cheapest Big Macs in the world, and you might be surprised at who made the list.

UKRAINE $1.64 (47 UAH)

Actual exchange rate 28.72

Implied exchange rate = 8.9

Ukraine is the cheapest country in which to live in in Europe – especially for foreigners. However, with low cost of living comes low purchasing power.

Ukraine has struggled to recover from the 2014 Euromaidan Revolution, and it has a shortage of skilled labor since many Ukrainians have had to seek job opportunities elsewhere – with a large portion of the labor force choosing to work in Poland.

Ukraine is also a country with incredibly high corruption – coming in at 5th place on the Economist Crony-Capitalism index as of 2016, and Ukrainians receive some of the lowest salaries in Europe. With the average salary hovering around $272, a $1.64 Big Mac might not be such a great deal.

EGYPT $1.93 (34.21 EGP)

Actual exchange rate = 17.70

Implied exchange rate = 6.48

Egypt has the 2nd cheapest Big Mac in the world at just $1.93.

Egyptian salaries are remarkably low, and steep price hikes in recent times have put more pressure on Egyptian citizens as basic services become increasingly expensive, including transport, electricity, and even drinkable water.

However, there are reassuring signs of economic recovery in Egypt with unemployment falling and indications of sustainable growth in the future.

With the exchange rate sitting around 1 dollar to 17 Egyptian pounds, this is a great time to travel to Egypt and get yourself a Big Mac.

The Big Mac Index for 2018 shows the Egyptian pound undervalued against the dollar by a whopping 63.4% with the adjusted index at a slightly less alarming 34.7%.

MALAYSIA $2.28 (9 MYR)

Actual exchange rate = 3.95

Implied exchange rate = 1.70

Political upheaval has plagued Malaysia in recent times, but this has not decreased this country’s attractiveness as a fantastic place to live thanks to its low costs of living (particularly for foreigners) and comfortably high quality of life.

In fact, the country is considered one of the best places in the world to retire, and in 2014, it came in third in the global retirement index. Malaysia has one of the most competitive economies in Asia, and it aims to become a high-income country by 2020.

Although Malaysia’s economy is growing rapidly, the price of a Big Mac there remains low.

Malaysians also enjoy reasonably high life expectancy, subsidized healthcare, reasonably good education, and strong industries, such as electronic equipment, petroleum, and liquefied natural gas production, which all point towards Malaysia becoming a developed nation over the next few years.

It has one of the most developed infrastructures in Asia – ranking 6th in Asia and 22nd in the world according to the Global Competitiveness Index published by the World Economic Forum.

Although the Malaysian economy is highly developed, it’s still home to the 3rd least expensive Big Mac on the planet.

According to the Big Mac Index, the Malaysian ringgit is undervalued by a staggering 56.9%, but that number is a drastically reduced in the adjusted index, which shows the currency to be undervalued by only 28.9% against the dollar.

RUSSIA $2.29 (130 RUB)

Actual exchange rate = 56.75

Implied exchange rate = 24.62

Russia is one of the largest emerging markets in the world. In 2015, Russia’s economy was the 6th largest in the world by purchasing power parity and 12th largest in terms of the GDP. It also enjoys one of the largest mineral and energy resource reserves in the world and produces much of the globe’s oil and natural gas.

Growth has recently slowed with the collapse of oil and gas prices as well as the stringent economic sanctions imposed after Russia’s annexation of Crimea from Ukraine in 2014, and doubt exists over the accuracy of data provided by Russia regarding important statistics about the cost of living in Russia.

Ultimately, these economic factors add up to a $2.29 Big Mac.

According to the raw index, the Russian ruble is undervalued by 56.6% against the US dollar while the adjusted index shows it at 28.1% undervalued.

TAIWAN $ 2.33 (69 TWD)

Actual exchange rate = 29.55

Implied exchange rate = 13.07

For many reasons, Taiwan has become an increasingly attractive destination for expats – particularly those looking to retire abroad in a country where the cost of living is comparatively lower.

The prices at McDonald’s in Taiwan are more or less in line with average meal prices at inexpensive restaurants in Taiwan, but Taiwanese street food still remains your cheapest option for a meal.

Taiwanese produce is known for being good quality and very cheap. Transport costs are also low, and average salaries are as well. All of these factors combine to give you a cheap and cheerful Taiwanese Big Mac Burger.

The New Taiwan dollar is undervalued by 55.8% according to the raw index, but the adjusted index has it slightly less undervalued at 38%.