How useful is the big mac index in measuring purchasing power parity
Purchasing power parity draws a comparison between different currencies through a market approach. The approach considers a basket of goods and claims that when the exchange rate is the same in both countries, then the money is in equilibrium. The McDonalds Big Mac was chosen by economists to explain this theory as it is a reflection of a market in a given location. It calculates the relative value of Big Mac to that in the United States, comparing other currencies against it. It explains the long-term effect of the economy on the money and vice versa.
The Big Mac is a standard measure of essential affordability. The things in a basket will differ in different countries; for instance, an American basket of groceries is different from a Chinese basket. Thus, pricing things that are different will result in a distinct reflection of the currency. The Big Mac, which is almost equal in price amongst many countries, is in a better position to explain and illustrate inflations in the money (Carbaugh, 106). This is in consideration of the cost of local goods and services, including business permits and rents that are considered in calculating the price of the Big Mac.
Despite being a real-world measurement, this index has its shortcomings. Dining in a McDonalds is quite expensive in most countries as compared to a local restaurant. The demand of the burger is therefore diminished in such countries (Carbaugh, 107). Using this as a global measure of purchasing power then does not show the accurate picture of the county’s market or strength of its currency. Besides, the price of a Big Mac will vary with its location. The price of a burger in the city will be higher compared to its price in a somewhat rural area, after considering production costs and market demand.
Besides, food consumption concerning fixed asset investment, clothing and education is a minimal contributor to gross domestic product (Wexler, 12). Countries in different economic phases have different consumption patterns. For instance, there is more food consumption in third world nations while there is more service consumption in developed nations. The purchasing power as well can be very different from the real income of the people in a given country.
The margin approach used by McDonald’s in determining the profit margin in markets does not reflect fair currency status. The high volume and low margin model aims at maximizing profits and thus leaves out so many factors that otherwise impact on the strength of a country’s currency (Wexler, 14). In this approach, the exchange rates of different countries can be undervalued against the US dollar. Nonetheless, the index fails to account for non-tradable components in its pricing and thus misleads the valuation of currencies against the US dollar.
The Big Mac index is not the perfect mode of expression as McDonald’s has outlets in 119 countries out of the 195 countries. Therefore, it isn’t elementary to use this methodology to analyze the purchasing power parity between the US dollar and the currencies of those left out states (Carbaugh, 111). The index does not follow assumptions under purchasing power parity. For instance, it is not traded across borders and thus is a little biased. The index only comes once a year and therefore cannot be used to explain forex trading indicators.
The Big Mac index is a short-lived hero as the world is changing into a vegetarian diet. Consumption of the burger in question is then going to decrease, and thus its sales will be reduced. Consequently, the index cannot be used to express future exchange rates and price deviations. it is only best to consider other forms of valuation to minimize bias while exploiting maximum credibility of chosen indexes.