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CHAPTER 1 CURRENCY A currency (from Middle English: curraunt, "in circulation", from Latin: currens, entis) in the most specific use of the word refers to money in any form when in actual use or circulation, as a medium of exchange, especially circulating paper money. This use is synonymous with banknotes, or (sometimes) with banknotes plus coins, meaning the physical tokens used for money by a government. A much more general use of the word currency is anything that is used in any circumstances, as a medium of exchange. In this use, "currency" is a synonym for the concept of money. A definition of intermediate generality is that a currency is a system of money (monetary units) in common use, especially in a nation. Under this definition, British pounds, U.S. dollars, and European euros are different types of currency, or currencies. Currencies in this definition need not be physical objects, but as stores of value are subject to trading between nations in foreign exchange markets, which determine the relative values of the different currencies. Currencies in the sense used by foreign exchange markets are defined by governments, and each type has limited boundaries of acceptance. The former definitions of the term "currency" are discussed in their respective synonymous articles banknote, coin, and money. The latter definition, pertaining to the currency systems of nations, is the topic of this article. Currencies can be classified into two monetary systems: fiat money and commodity money, depending on what guarantees the value (the economy at large vs. the government's
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physical metal reserves). Some currencies are legal tender in certain jurisdictions, which means they cannot be refused as payment for debt. Others are simply traded for their economic value. Digital currency arose with the popularity of computers and the Internet.
History Currency evolved from two basic innovations, both of which had occurred by 2000 BC. Originally money was a form of receipt, representing grain stored in temple granaries in Sumer in ancient Mesopotamia, then Ancient Egypt. In this first stage of currency, metals were used as symbols to represent value stored in the form of commodities. This formed the basis of trade in the Fertile Crescent for over 1500 years. However, the collapse of the Near Eastern trading system pointed to a flaw: in an era where there was no place that was safe to store value, the value of a circulating medium could only be as sound as the forces that defended that store. Trade could only reach as far as the credibility of that military. By the late Bronze Age, however, a series of treaties had established safe passage for merchants around the Eastern Mediterranean, spreading from Minoan Crete and Mycenae in the northwest to Elam and Bahrain in the southeast. It is not known what was used as a currency for these exchanges, but it is thought that ox-hide shaped ingots of copper, produced in Cyprus, may have functioned as a currency. It is thought that the increase in piracy and raiding associated with the Bronze Age collapse, possibly produced by the Peoples of the Sea, brought the trading system of ox hide ingots to an end. It was only with the recovery of Phoenician trade in the 10th and 9th centuries BC that saw a return to prosperity, and the appearance of real coinage, possibly first in Anatolia with Croesus of Lydia and subsequently 2|Page
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with the Greeks and Persians. In Africa many forms of value store have been used, including beads, ingots, ivory, various forms of weapons, livestock, the manilla currency, and ochre and other earth oxides. The manilla rings of West Africa were one of the currencies used from the 15th century onwards to sell slaves. African currency is still notable for its variety, and in many places various forms of barter still apply.
Modern currencies Currency use is based on the concept of lex monetae; that a sovereign state decides which currency it shall use. Currently, the International Organization for Standardization has introduced a three-letter system of codes (ISO 4217) to define currency (as opposed to simple names or currency signs), in order to remove the confusion that there are dozens of currencies called the dollar and many called the franc. Even the pound is used in nearly a dozen different countries; most of these are tied to the Pound Sterling, while the remainder has varying values. In general, the three-letter code uses the ISO 3166-1 country code for the first two letters and the first letter of the name of the currency (D for dollar, for instance) as the third letter. United States currency, for instance is globally referred to as USD.
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Currency convertibility Convertibility of a currency determines the ability of an individual, corporate or government to convert its local currency to another currency or vice versa with or without central bank/government intervention. Based on the above restrictions or free and readily conversion features, currencies are classified as:
Fully convertible When there are no restrictions or limitations on the amount of currency that can be traded on the international market and the government does not artificially impose a fixed value or minimum value on the currency in international trade. The US dollar is an example of a fully convertible currency and, for this reason; US dollars are one of the major currencies traded in the foreign exchange market.
Partially convertible Central banks control international investments flowing in and out of the country, while most domestic trade transactions are handled without any special requirements, there are significant restrictions on international investing and special approval is often required in order to convert into other currencies. The Indian rupee is an example of a partially convertible currency.
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Nonconvertible Neither participates in the international FOREX market nor allows conversion of these currencies by individuals or companies. As a result, these currencies are known as blocked currencies. e.g.: North Korean won and the Cuban peso.
Definition of 'Currency'
A generally accepted form of money, including coins and paper notes, which is issued by a government and circulated within an economy. Used as a medium of exchange for goods and services, currency is the basis for trade. Investopedia explains 'Currency'
Generally speaking, each country has its own currency. For example, Switzerland's official currency is the Swiss franc, and Japan's official currency is the yen. An exception would be the euro, which is used as the currency for several European countries.
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CHAPTER 2 EXCHANGE RATE In finance, an exchange rate (also known as a foreign-exchange rate, forex rate, FX rate or Agio) between two currencies is the rate at which one currency will be exchanged for another. It is also regarded as the value of one country’s currency in terms of another currency. For example, an interbank exchange rate of 91 Japanese yen (JPY, ¥) to the United States dollar (US$) means that ¥91 will be exchanged for each US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are determined in the foreign exchange market which is open to a wide range of different types of buyers and sellers where currency trading is continuous: 24 hours a day except weekends, i.e. trading from 20:15 GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers to the current exchange rate. The forward exchange rate refers to an exchange rate that is quoted and traded today but for delivery and payment on a specific future date. In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer's margin (or profit) in trading, or else the margin may be recovered in the form of a "commission" or in some other way. Different rates may also be quoted for cash (usually notes only), a documentary form (such as traveler's cheques) or electronically (such as a debit card purchase). The higher rate on documentary transactions is due to the additional time and cost of clearing the document, while the cash is available for resale immediately. Some
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dealers on the other hand prefer documentary transactions because of the security concerns with cash.
Retail exchange market People may need to exchange currencies in a number of situations. For example, people intending to travel to another country may buy foreign currency in a bank in their home country, where they may buy foreign currency cash, traveler's cheques or a travel-card. From a local money changer they can only buy foreign cash. At the destination, the traveler can buy local currency at the airport, either from a dealer or through an ATM. They can also buy local currency at their hotel, a local money changer, through an ATM, or at a bank branch. When they purchase goods in a store and they do not have local currency, they can use a credit card, which will convert to the purchaser's home currency at its prevailing exchange rate. If they have traveler's cheques or a travel card in the local currency, no currency exchange is necessary. Then, if a traveler has any foreign currency left over on their return home, they may want to sell it, which they may do at their local bank or money changer. The exchange rate as well as fees and charges can vary significantly on each of these transactions, and the exchange rate can vary from one day to the next. There are variations in the quoted buying and selling rates for a currency between foreign exchange dealers and forms of exchange, and these variations can be significant. For example, consumer exchange rates used by Visa and MasterCard offer the most favorable exchange rates available, according to a Currency Exchange Study conducted by CardHub.com. This studied consumer banks in the U.S., and Travelex, showed that the credit card networks save travelers about 8% relative to banks and roughly 15% relative to airport companies. 7|Page
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Quotations A currency pair is the quotation of the relative value of a currency unit against the unit of another currency in the foreign exchange market. The quotation EUR/USD 1.3533 means that 1 Euro is able to buy 1.3533 US dollar. In other words, this is the price of a unit of Euro in US dollar. Here, EUR is called the "Fixed currency", while USD is called the "Variable currency". There is a market convention that determines which is the fixed currency and which is the variable currency. In most parts of the world, the order is: EUR – GBP – AUD – NZD – USD – others. Accordingly, a conversion from EUR to AUD, EUR is the fixed currency, AUD is the variable currency and the exchange rate indicates how many Australian dollars would be paid or received for 1 Euro. Cyprus and Malta which were quoted as the base to the USD and others were recently removed from this list when they joined the Eurozone. In some areas of Europe and in the non-professional market in the UK, EUR and GBP are reversed so that GBP is quoted as the base currency to the euro. In order to determine which the base currency is where both currencies are not listed (i.e. both are "other"), market convention is to use the base currency which gives an exchange rate greater than 1.000. This avoids rounding issues and exchange rates being quoted to more than four decimal places. There are some exceptions to this rule, for example, the Japanese often quote their currency as the base to other currencies. Quotes using a country's home currency as the price currency (for example, EUR 0.735342 = USD 1.00 in the Eurozone) are known as direct quotation or price quotation (from that country's perspective) and are used by most countries. 8|Page
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Quotes using a country's home currency as the unit currency (for example, USD 1.35991 = EUR 1.00 in the Eurozone) are known as indirect quotation or quantity quotation and are used in British newspapers and are also common in Australia, New Zealand and the Eurozone. Using direct quotation, if the home currency is strengthening (that is, appreciating, or becoming more valuable) then the exchange rate number decreases. Conversely, if the foreign currency is strengthening, the exchange rate number increases and the home currency is depreciating. Market convention from the early 1980s to 2006 was that most currency pairs were quoted to four decimal places for spot transactions and up to six decimal places for forward outrights or swaps. (The fourth decimal place is usually referred to as a "pip"). An exception to this was exchange rates with a value of less than 1.000 which were usually quoted to five or six decimal places. Although there is not any fixed rule, exchange rates with a value greater than around 20 were usually quoted to three decimal places and currencies with a value greater than 80 were quoted to two decimal places. Currencies over 5000 were usually quoted with no decimal places (for example, the former Turkish Lira). e.g. (GBPOMR: 0.765432 - : 1.4436 - EURJPY: 165.29). In other words, quotes are given with five digits. Where rates are below 1, quotes frequently include five decimal places. In 2005, Barclays Capital broke with convention by offering spot exchange rates with five or six decimal places on their electronic dealing platform. The contraction of spreads (the difference between the bid and ask rates) arguably necessitated finer pricing and gave the banks the ability to try and win transaction on multibank trading platforms where all banks may otherwise have been quoting the same price. A number of other banks have now followed this system. 9|Page
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Definition of 'Exchange Rate' The price of a nation’s currency in terms of another currency. An exchange rate thus has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In a direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. In an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency. An exchange rate that does not have the domestic currency as one of the two currency components is known as a cross currency, or cross rate
Investopedia explains 'Exchange Rate'
An exchange rate has a base currency and a counter currency. In a direct quotation, the foreign currency is the base currency and the domestic currency is the counter currency. In an indirect quotation, the domestic currency is the base currency and the foreign currency is the counter currency.
Most exchange rates use the US dollar as the base currency and other currencies as the counter currency. However, there are a few exceptions to this rule, such as the euro and Commonwealth currencies like the British pound, Australian dollar and New Zealand dollar.
Exchange rates for most major currencies are generally expressed to four places after the decimal, except for currency quotations involving the Japanese yen, which are quoted to two places after the decimal.
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CHAPTER 3 FLUCTUATIONS IN EXCHANGE RATES
A market-based exchange rate will change whenever the values of either of the two component currencies change. A currency will tend to become more valuable whenever demand for it is greater than the available supply. It will become less valuable whenever demand is less than available supply (this does not mean people no longer want money, it just means they prefer holding their wealth in some other form, possibly another currency). Increased demand for a currency can be due to either an increased transaction demand for money or an increased speculative demand for money. The transaction demand is highly correlated to a country's level of business activity, gross domestic product (GDP), and employment levels. The more people that are unemployed, the less the public as a whole will spend on goods and services. Central banks typically have little difficulty adjusting the available money supply to accommodate changes in the demand for money due to business transactions. Speculative demand is much harder for central banks to accommodate, which they influence by adjusting interest rates. A speculator may buy a currency if the return (that is the interest rate) is high enough. In general, the higher a country's interest rates, the greater will be the demand for that currency. It has been argued that such speculation can undermine real economic growth, in particular since large currency speculators may deliberately create downward pressure on a currency by shorting in order to force that central bank to buy their own currency to keep it stable.
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(When that happens, the speculator can buy the currency back after it depreciates, close out their position, and thereby take a profit.) For carrier companies shipping goods from one nation to another, exchange rates can often impact them severely. Therefore, most carriers have a CAF charge to account for these fluctuations. Aside from factors such as interest rates and inflation, the exchange rate is one of the most important determinants of a country's relative level of economic health. Exchange rates play a vital role in a country's level of trade, which is critical to most every free market economy in the world. For this reason, exchange rates are among the most watched, analyzed and governmentally manipulated economic measures. But exchange rates matter on a smaller scale as well: they impact the real return of an investor's portfolio. Here we look at some of the major forces behind exchange rate movements.
Overview Before we look at these forces, we should sketch out how exchange rate movements affect a nation's trading relationships with other nations. A higher currency makes a country's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country's balance of trade, while a lower exchange rate would increase it.
Determinants of Exchange Rates Numerous factors determine exchange rates, and all are related to the trading relationship between two countries. Remember, exchange rates are relative, and are expressed as a comparison of the currencies of two countries. The following are 12 | P a g e
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some of the principal determinants of the exchange rate between two countries. Note that these factors are in no particular order; like many aspects of economics, the relative importance of these factors is subject to much debate.
1. Differentials in Inflation As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. During the last half of the twentieth century, the countries with low inflation included Japan, Germany and Switzerland, while the U.S. and Canada achieved low inflation only later. Those countries with higher inflation typically see depreciation in their currency in relation to the currencies of their trading partners. This is also usually accompanied by higher interest rates. (To learn more, see CostPush Inflation Versus Demand-Pull Inflation.)
2. Differentials in Interest Rates Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates, central banks exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates - that is, lower interest rates tend to decrease exchange rates.
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3. Current-Account Deficits The current account is the balance of trade between a country and its trading partners, reflecting all payments between countries for goods, services, interest and dividends. A deficit in the current account shows the country is spending more on foreign trade than it is earning, and that it is borrowing capital from foreign sources to make up the deficit. In other words, the country requires more foreign currency than it receives through sales of exports, and it supplies more of its own currency than foreigners demand for its products. The excess demand for foreign currency lowers the country's exchange rate until domestic goods and services are cheap enough for foreigners, and foreign assets are too expensive to generate sales for domestic interests. (For more, see Understanding The Current Account In The Balance Of Payments.)
4. Public Debt Countries will engage in large-scale deficit financing to pay for public sector projects and governmental funding. While such activity stimulates the domestic economy, nations with large public deficits and debts are less attractive to foreign investors. The reason? A large debt encourages inflation, and if inflation is high, the debt will be serviced and ultimately paid off with cheaper real dollars in the future.
In the worst case scenario, a government may print money to pay part of a large debt, but increasing the money supply inevitably causes inflation. Moreover, if a government is not able to service its deficit through domestic means (selling domestic bonds, increasing the money supply), then it must increase the supply of securities for sale to foreigners, thereby lowering their prices. Finally, a large debt may prove worrisome to foreigners if they believe the country risks defaulting on 14 | P a g e
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its obligations. Foreigners will be less willing to own securities denominated in that currency if the risk of default is great. For this reason, the country's debt rating (as determined by Moody's or Standard & Poor's, for example) is a crucial determinant of its exchange rate.
5. Terms of Trade A ratio comparing export prices to import prices, the terms of trade is related to current accounts and the balance of payments. If the price of a country's exports rises by a greater rate than that of its imports, its terms of trade have favorably improved. Increasing terms of trade shows greater demand for the country's exports. This, in turn, results in rising revenues from exports, which provides increased demand for the country's currency (and an increase in the currency's value). If the price of exports rises by a smaller rate than that of its imports, the currency's value will decrease in relation to its trading partners.
6. Political Stability and Economic Performance Foreign investors inevitably seek out stable countries with strong economic performance in which to invest their capital. A country with such positive attributes will draw investment funds away from other countries perceived to have more political and economic risk. Political turmoil, for example, can cause a loss of confidence in a currency and a movement of capital to the currencies of more stable countries.
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CHAPTER 4 LIMITATIONS While economists widely cite the Big Mac index as a reasonable real-world measurement of purchasing power parity, the burger methodology has some limitations. In many countries, eating at international fast-food chain restaurants such as McDonald's is relatively expensive in comparison to eating at a local restaurant and the demand for Big Macs is not as large in countries such as India as in the United States. Social status of eating at fast food restaurants such as McDonald's in a local market, what proportion of sales might be to expatriates, local taxes, levels of competition, and import duties on selected items may not be representative of the country's economy as a whole. In addition, there is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries: this is the theoretical reason for PPPs being different from market exchange rates over time. The relative cost of high-margin products, such as essential pharmaceutical products, or cellular telephony might compare local capacity and willingness to pay, as much as relative currency values. Nevertheless, McDonald's is also using different commercial strategies which can result in huge differences for a product. Overall, the price of a Big Mac will be a reflection of its local production and delivery cost, the cost of advertising (considerable in some areas), and most importantly what the local market will bear — quite different from country to country, and not all a reflection of relative currency values.
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In some markets, a high-volume and low-margin approach makes most sense to maximize profit, while in others a higher margin will generate more profit. Thus the relative prices reflect more than currency values. For example, a hamburger costs only €1 in France, and €1.50 in Belgium, but overall, McDonald's restaurants are cheaper in Belgium. Prices of Big Macs can also vary greatly between different areas within a country. For example, a Big Mac sold in New York City will be more expensive than one sold at a McDonald's located in a rural area of a neighboring state. One other example is that Russia has one of the cheapest Big Macs, at the same time as Moscow usually is near the top on lists of costs for visiting business people. Standard food ingredients are cheap in Russia, while restaurants suitable for business dinners with English speaking staff are expensive.
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CHAPTER 5 MANIPULATION Critics of the presidency of Cristina Fernandez de Kirchner in Argentina and many economists believe that the government has for years falsified consumer price data to understate the country's true inflation rate. The Economist stated in January 2011 that Big Mac index "does support claims that Argentina’s government is cooking the books. The gap between its average annual rate of burger inflation (19%) and its official rate (10%) is far bigger than in any other country." That year the press began reporting on unusual behavior by the more than 200 Argentinean McDonald's restaurants. They no longer prominently advertised Big Macs for sale and the sandwich, both individually and as part of value meals, was being sold for an unusually low price compared to other items. Guillermo Moreno, Secretary of Commerce in the Kirchner government, reportedly forced McDonald's to sell the Big Mac at an artificially low price to manipulate the country's performance on the Big Mac index. In June 2012 the price of the Big Mac value meal suddenly rose by 26%, closer to that of other meals, after The Economist, The New York Times, and other media reported on the unusual pricing. A Buenos Aires newspaper stated "Moreno loses the battle".
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CHAPTER 6 THE BIG MAC INDEX The Big Mac index, also known as Big Mac PPP, is a survey done by The Economist magazine that is used to measure the purchasing power parity (PPP) between nations, using the price of a Big Mac as the benchmark. Using the idea of PPP from economics, any changes in exchange rates between nations would be seen in the change in price of a basket of goods which remains constant across borders. The Big Mac index suggests that, in theory, changes in exchange rates between currencies should affect the price that consumers pay for a Big Mac in a particular nation, replacing the "basket" with the popular hamburger.
For example, if the price of a Big Mac is $4.00 in the U.S. as compared to 2.5 pounds sterling in Britain, we would expect that the exchange rate would be 1.60 (4/2.5 = 1.60). If the exchange rate of dollars to pounds is any greater, the Big Mac Index would state that the pound was over-valued, any lower and it would be under-valued.
The index is imperfect at best. First, the Big Mac's price is decided by the McDonalds Corporation and can greatly affect the Big Mac index. Also, the Big Mac differs across the world in size, ingredients and availability. That being said, the index is meant to be light-hearted and is a great example of PPP and is used by many schools and universities to teach students about PPP. THE Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates 19 | P a g e
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should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. For example, the average price of a Big Mac in America in July 2014 was $4.80; in China it was only $2.73 at market exchange rates. So the "raw" Big Mac index says that the Yuan
was
undervalued
by
43%
at
that
time.
Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible. Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. For those who take their fast food more seriously, we have also calculated a gourmet version of the index.
This adjusted index addresses the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. The adjusted index uses the “line of best fit” between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country, given its income per person, and its actual price gives a supersized measure of currency under- and over-valuation
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Comparison issues The Big Mac (and virtually all sandwiches) varies from country to country with differing nutritional values, weights and even nominal size differences. Not all Big Mac burgers offered by the chain are exclusively beef. In India — which is a predominantly Hindu country — beef burgers are not available at any McDonald's outlets. The chicken Maharaja Mac serves as a substitute for the Big Mac. There is a lot of variance with the exclusively Beef "Big Mac": the Australian version of the Big Mac has 22% less energy than the Canadian version, and is 8% lighter than the version sold in Mexico. On 1 November 2009, all three of the McDonald's in Iceland closed, primarily due to the chain's high cost of importing most of the chain's meat and vegetables from the Eurozone. At the time, a Big Mac in Iceland cost 650 krona ($5.29), and the 20% price increase that would have been needed to stay in business would have increased that cost to 780 krona ($6.36). Fish and lamb meat is produced in Iceland, while beef must be imported.
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CHAPTER 7 CONCEPT OF BIG MAC INDEX Hamburger Economics: The Big Mac Index Purchasing power parity (PPP) states that the price of a good in one country is equal to its price in another country after adjusting for the exchange rate between the two countries.
As a light-hearted annual test of PPP, The Economist has tracked the price of McDonald's Big Mac burger in many countries since 1986. This experiment known as the Big Mac PPP - and similar tests have been underway for decades. Here we take a look at this unique indicator, and find out what the price of the ubiquitous Big Mac in a given country can tell us about its wealth.
To illustrate PPP, let's assume the U.S. dollar/Mexican peso exchange rate is 1/15 pesos. If the price of a Big Mac in the U.S. is $3, the price of a Big Mac in Mexico would be 45 pesos assuming the countries have purchasing power parity.
If, however, the price of a Big Mac in Mexico is 60 pesos, Mexican fast-food shop owners could buy Big Macs in the U.S. for $3, at a cost of 45 pesos, and sell each in Mexico for 60 pesos, making a 15-peso risk-free gain. (Although this is unlikely with hamburgers specifically, the concept applies to other goods as well.)
To exploit this arbitrage, the demand for U.S. Big Macs would drive the U.S. Big Mac price up to $4, at which point the Mexican fast-food shop owners would have no risk-free gain. This is because it would cost them 60 pesos to buy U.S. Big 22 | P a g e
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Macs, which is the same price as in Mexico – thus restoring PPP.
PPP also means there will be parity among prices for the same good in all countries (the law of one price). (To learn more about capitalizing on the relationship between price and liquidity, read our related article Arbitrage Squeezes Profit From Market Inefficiency.)
Currency Value In the example above, where the Big Mac is at a price of $3 and 60 pesos, a PPP exchange rate of US$1 to 20 pesos is implied. The peso is overvalued against the U.S. dollar by 33% (as per the calculation: (20-15)/15), and the dollar is undervalued against the peso by 25% (as per the calculation: (0.05-0.067)/0.067).
In the arbitrage opportunity above, the actions of many Mexican fast-food shop owners selling pesos and buying dollars to exploit the price arbitrage would drive the value of the peso down (depreciate) and the dollar up (appreciate). Of course, the actions of exploiting a Big Mac alone is not sufficient to drive a country's exchange rate up or down, but if applied to all goods - in theory - it might be sufficient to move a country's exchange rate so that price parity is restored. For example, if the price of goods in Mexico is high relative to the same goods in the U.S., U.S. buyers would favor their domestic goods and shun Mexican goods. This loss of interest would eventually force Mexican sellers to lower the price of their goods until they are at parity with U.S. goods.
Alternately, the Mexican government could allow the peso to depreciate against the dollar, so U.S. buyers pay no more to buy their goods from Mexico. (Read 23 | P a g e
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Forces Behind Exchange Rates to learn more about what affects a currencies relative strength.)
PURCHASING POWER PARITY Purchasing power parity (PPP) is a component of some economic theories and is a technique used to determine the relative value of different currencies. Theories that invoke purchasing power parity assume that in some circumstances (for example, as a long-run tendency) it would cost exactly the same number of, say, US dollars to buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use those dollars directly in purchasing the market basket of goods. The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be at par with the purchasing power of the two countries' currencies. Using that PPP rate for hypothetical currency conversions, a given amount of one currency thus has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency. Observed deviations of the exchange rate from purchasing power parity are measured by deviations of the real exchange rate from its PPP value of 1. PPP exchange rates help to minimize misleading international comparisons that can arise with the use of market exchange rates. For example, suppose that two countries produce the same physical amounts of goods as each other in each of two different years. Since market exchange rates fluctuate substantially, when the GDP 24 | P a g e
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of one country measured in its own currency is converted to the other country's currency using market exchange rates, one country might be inferred to have higher real GDP than the other country in one year but lower in the other; both of these inferences would fail to reflect the reality of their relative levels of production. But if one country's GDP is converted into the other country's currency using PPP exchange rates instead of observed market exchange rates, the false inference will not occur. The idea originated with the School of Salamanca in the 16th century and was developed in its modern form by Gustav Cassel in 1918. The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency. Another interpretation is that the difference in the rate of change in prices at home and abroad—the difference in the inflation rates—is equal to the percentage depreciation or appreciation of the exchange rate. Deviations from parity imply differences in purchasing power of a "basket of goods" across countries, which means that for the purposes of many international comparisons, countries' GDPs or other national income statistics need to be "PPPadjusted" and converted into common units. The best-known purchasing power adjustment is the Geary–Khamis dollar (the "international dollar"). The real exchange rate is then equal to the nominal exchange rate, adjusted for differences in price levels. If purchasing power parity held exactly, then the real exchange rate would always equal one. However, in practice the real exchange rates exhibit both short run and long run deviations from this value, for example due to reasons illuminated in the Balassa–Samuelson theorem. 25 | P a g e
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There can be marked differences between purchasing power adjusted incomes and those converted via market exchange rates. For example, the World Bank's World Development Indicators 2005 estimated that in 2003, one Geary-Khamis dollar was equivalent to about 1.8 Chinese yuan by purchasing power parity[6]— considerably different from the nominal exchange rate. This discrepancy has large implications; for instance, when converted via the nominal exchange rates GDP per capita in India is about US$1,704 while on a PPP basis it is about US$3,608.[8] At the other extreme, Denmark's nominal GDP per capita is around US$62,100, but its PPP figure is US$37,304. MEASUREMENT The PPP exchange-rate calculation is controversial because of the difficulties of finding comparable baskets of goods to compare purchasing power across countries. Estimation of purchasing power parity is complicated by the fact that countries do not simply differ in a uniform price level; rather, the difference in food prices may be greater than the difference in housing prices, while also less than the difference in entertainment prices. People in different countries typically consume different baskets of goods. It is necessary to compare the cost of baskets of goods and services using a price index. This is a difficult task because purchasing patterns and even the goods available to purchase differ across countries. Thus, it is necessary to make adjustments for differences in the quality of goods and services. Furthermore, the basket of goods representative of one economy will vary from that of another: Americans eat more bread; Chinese more rice. Hence a PPP calculated using the US consumption as a base will differ from that calculated 26 | P a g e
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using China as a base. Additional statistical difficulties arise with multilateral comparisons when (as is usually the case) more than two countries are to be compared. Various ways of averaging bilateral PPPs can provide a more stable multilateral comparison, but at the cost of distorting bilateral ones. These are all general issues of indexing; as with other price indices there is no way to reduce complexity to a single number that is equally satisfying for all purposes. Nevertheless, PPPs are typically robust in the face of the many problems that arise in using market exchange rates to make comparisons. For example, in 2005 the price of a gallon of gasoline in Saudi Arabia was USD 0.91, and in Norway the price was USD 6.27. The significant differences in price wouldn't contribute to accuracy in a PPP analysis, despite all of the variables that contribute to the significant differences in price. More comparisons have to be made and used as variables in the overall formulation of the PPP. When PPP comparisons are to be made over some interval of time, proper account needs to be made of inflationary effects. Law of one price Although it may seem as if PPPs and the law of one price are the same, there is a difference: the law of one price applies to individual commodities whereas PPP applies to the general price level. If the law of one price is true for all commodities then PPP is also therefore true; however, when discussing the validity of PPP, some argue that the law of one price does not need to be true exactly for PPP to be valid. If the law of one price is not true for a certain commodity, the price levels will not differ enough from the level predicted by PPP. 27 | P a g e
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The purchasing power parity theory states that the exchange rate between one currency and another currency is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent.
Short-Term vs. Long-Term Parity
Empirical evidence has shown that for many goods and baskets of goods, PPP is not observed in the short term, and there is uncertainty over whether it applies in the long term. Pakko & Pollard cite several confounding factors as to why PPP theory does not line up with reality in their paper "Burgernomics" (2003). The reasons for this differentiation include:
Transport Costs: Goods that are not available locally will need to be imported, resulting in transport costs. Imported goods will thus sell at a relatively higher price than the same goods available from local sources.
Taxes: When government sales taxes, such as value-added tax (VAT), are high in one country relative to another, this means goods will sell at a relatively higher price in the high-tax country.
Government Intervention: Import tariffs add to the price of imported goods. Where these are used to restrict supply, demand rises, causing price of the goods to rise as well. In countries where the same good is unrestricted and abundant, its price will be lower.Governments that restrict exports will see a good's price rise in importing countries facing a shortage, and fall in exporting countries where its supply is increasing. (To learn how importing and exporting influences currency value, be sure to read Current Account Deficits.) 28 | P a g e
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Non-Traded Services: The Big Mac's price is composed of input costs that are not traded. Therefore, those costs are unlikely to be at parity internationally. These costs can include the cost of premises, the cost of services such as insurance and heating and especially the cost of labor. According to PPP, in countries where non-traded service costs are relatively high, goods will be relatively expensive, causing such countries' currencies to be over-valued relative to currencies in countries with low costs of nontraded services.
Market Competition: Goods might be deliberately priced higher in a country because the company has a competitive advantage over other sellers, either because it has a monopoly or is part of a cartel of companies that manipulate prices. The company's sought-after brand might allow it to sell at a premium price as well. Conversely, it might take years of offering goods at a reduced price in order to establish a brand and add a premium, especially if there are cultural or political hurdles to overcome.
Inflation: The rate at which the price of goods (or baskets of goods) is changing in countries, the inflation rate, can indicate the value of those countries' currencies. Such relative PPP overcomes the need for goods to be the same when testing absolute PPP discussed above.
The Bottom Line PPP dictates that the price of an item in one currency should be the same price in any other currency, based on the currency pair's exchange rate at that time. This relationship often does not hold in reality because of several confounding factors. However, over a period of years, when prices are adjusted for inflation, relative PPP has been seen to hold for some currencies.
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Definition of 'Big Mac PPP'
A survey done by The Economist that determines what a country's exchange rate would have to be for a Big Mac in that country to cost the same as it does in the United States. Purchase power parity (PPP) is the theory that currencies adjust according to changes in their purchasing power. With the Big Mac PPP, purchasing power is reflected by the price of a McDonald's Big Mac in a particular country. The measure gives an impression of how overvalued or undervalued a currency is. Investopedia explains 'Big Mac PPP'
The calculation of the Big Mac PPP-adjusted exchange rate looks at the price of a Big Mac in a given country and divides it by the price of a U.S. Big Mac. Let's say that we are looking at the Big Mac in China. If a Chinese Big Mac is 10.41 renminbi (RMB) and
.
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CHAPTER 8 COMPARISON OF EXCHANGE RATES WITH BIG MAC INDEX Lighthearted, tongue-in-cheek and half-hearted are just a few descriptions attributed to the Economist's introduction of the Big Mac Index since its invention in 1986. How serious they were with this index is questionable, but since it was devised, whole cottage industries have been developed by economists, traders and teachers devoted to the concept of finding the perfect arbitrage trade.
The idea behind the Big Mac Index was to measure the percentage of overvaluation and undervaluation between two currencies in each nation by comparing prices of a Big Mac hamburger, using the U.S. dollar through the Federal Reserve's trade-weighted average as its base. This is effective because Big Macs are sold in almost 120 nations. Since the Big Mac became the standard consumer good common to all nations, devising a method for determining overvaluation and undervaluation of currency pairs would be based on the formula of
purchasing
power
parity.
Purchasing Power What?
To determine purchasing power parity, factor the price of a Big Mac in nation X in the local currency. Next, determine the price of a Big Mac in U.S. dollars. Purchasing power parity is the price of a Big Mac in nation X divided by the price of a Big Mac in U.S. dollars. Take this figure and divide it by the Federal Reserve's trade-weighted average, the exchange rate. Essentially, the exchange rate is the 31 | P a g e
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percentage of under- or overvaluation of a currency. A lower price means the first currency is undervalued compared to the second currency, while a higher price means the second currency is overvalued in percentage terms against the dollar.
The concept behind this is that prices will eventually equalize over time. While this simple formula may serve as a theoretical guide to determine under- and overvalued currencies, practicality says many limitations exist in the short and long term
for
measuring
evaluations
and
achieving
successful
trades.
Prior research suggests short-term durations will never achieve parity because the short length of time will never equalize prices. Longer terms may see deviations in prices last for many years without a guaranteed means of achieving real parity. One reason for this is that some nations undervalue their currency purposefully, especially if they are export-dependent, to aid their exporters and earn more in foreign reserves. This is a constant revenue stream and a means for emerging market
nations
to
become
competitive
in
the
world
market.
Apples to Oranges
Another conundrum for the long term is the measure of the trade-weighted average, which can remain a constant for many years. Compare this to the prices of a Big Mac, which is market driven, and you can see how flawed the Big Mac Index can be. Prices of Big Macs may not even remain constant within nations. Therefore, the comparison of the Big Mac Index is apples to oranges where prices may never equalize and parity may never be achieved. Factor in the hidden costs involved between nations and the index can remain skewed for many, many years. 32 | P a g e
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For example, many nations institute a value-added tax, or a tax on goods at the border. This tax must be valued with any transportation costs. Also, inflation is never the same between nations. This can erode prices where high inflation exists. The cost of goods and commodity prices may be quite different depending on the nation, which may skew not only the Big Mac Index but also the original cost of the Big Mac in a given location.
Wage costs and further trade restrictions between nations can also skew the longerterm implications for the Big Mac Index as well as the cost of the Big Mac. Factor a possible war among or between nations and a possible financial crisis, and the Big Mac Index may never achieve parity.
Not to mention the fact that the index can't predict impending crisis yet prices of a Big Mac may be altered due to a supply and demand problem. Various people in many nations accept and reject eating a Big Mac based on cultural and religious reasons. More differences may exist between populations of the countryside and the more populous cities.
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The Bottom Line
Implementing a trade based on trade-weighted exchange rates may turn out to be unprofitable compared to a normal trade based on current market driven spot prices and current market driven Big Mac prices. Spot prices move based on the dollar index, a tradable instrument on the New York Board of Trade. Whole cottage industries, websites and college lectures have devoted themselves to this concept of purchasing power parity based on the cost of the Big Mac hamburger, but that parity may never exist.
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CHAPTER 9 STUDY OF PRICE MOVEMENT An example of one measure of the law of one price, which underlies purchasing power parity, is the Big Mac Index, popularized by The Economist, which compares the prices of a Big Mac burger in McDonald's restaurants in different countries. The Big Mac Index is presumably useful because although it is based on a single consumer product that may not be typical, it is a relatively standardized product that includes input costs from a wide range of sectors in the local economy, such as agricultural commodities (beef, bread, lettuce, cheese), labor (blue and white collar), advertising, rent and real estate costs, transportation, etc. In theory, the law of one price would hold that if, to take an example, the Canadian dollar were to be significantly overvalued relative to the U.S. dollar according to the Big Mac Index, that gap should be unsustainable because Canadians would import their Big Macs from or travel to the U.S. to consume them, thus putting upward demand pressure on the U.S. dollar by virtue of Canadians buying the U.S. dollars needed to purchase the U.S.-made Big Macs and simultaneously placing downward supply pressure on the Canadian dollar by virtue of Canadians selling their currency in order to buy those same U.S. dollars. The alternative to this exchange rate adjustment would be an adjustment in prices, with Canadian McDonald's stores compelled to lower prices to remain competitive. Either way, the valuation difference should be reduced assuming perfect competition and a perfectly tradable good. In practice, of course, the Big Mac is not a perfectly tradable good and there may also be capital flows that sustain relative demand for the Canadian dollar. The difference in price may have its 35 | P a g e
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origins in a variety of factors besides direct input costs such as government regulations and product differentiation. However, in some emerging economies, western fast food represents an expensive niche product price well above the price of traditional staples—i.e. the Big Mac is not a mainstream 'cheap' meal as it is in the West, but a luxury import. This relates back to the idea of product differentiation: the fact that few substitutes for the Big Mac are available confers market power on McDonald's. For example, In India, the costs of local fast food like Vada Pav are comparative to what the Big Mac signifies in, say U.S.A. Additionally, with countries like Argentina that have abundant beef resources, consumer prices in general may not be as cheap as implied by the price of a Big Mac. The following table, based on data from The Economist's January 2013 calculations, shows the under (−) and over (+) valuation of the local currency against the U.S. dollar in %, according to the Big Mac index. To take an example calculation, the local price of a Big Mac in Hong Kong when converted to U.S. dollars at the market exchange rate was $2.19 or 50% of the local price for a Big Mac in the U.S. of $4.37. Hence the Hong Kong dollar was deemed to be 50% undervalued relative to the U.S. dollar on a PPP basis. Here’s a little economic talk for you so you can an idea of what’s going on. The perfect arbitrage trade is the synchronized buy and sell of an asset so you can make some money from the difference in price. What you are attempting to do is take advantage of price differences in similar investment vehicles. Arbitrage comes about due to market inefficiencies. It helps makes sure that there aren’t large price variations for fair value over the long term.
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Now enter technology. As advanced and fast as trading systems are now, it’s hard to take advantage of mispriced assets. A lot of traders have systems to check on currency fluctuations. But if they do occur, it’s usually gone within moments. Given the advancement in technology it has become extremely difficult to profit from mispricing in the market. So the purpose of the Big Mac Index was to gauge the percentage of overvaluation and/or undervaluation between two currencies in two different countries by using the price of an actual Big Mac. Why a Big Mac? You have to love the world’s appetite for fast food. Big Macs are sold in nearly 120 countries becoming a standard consumer good. Then, take the U.S. dollar through the Federal Reserve’s trade-weighted average and use that as your base. Now you can use the formula of purchasing power parity to determine if currencies are over or undervalued.
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PURCHASING POWER PARITY Think of PPP as a simple equation. Let’s look at it step by step:
First of all find the price of a Big Mac in the country you are attempting to value in its local currency.
Next, find the price of a Big Mac in U.S. dollars.
PPP is the price of the Big Mac in the initial country divided by the price of a Big Mac in U.S. dollars.
If you take this number and divide it by the Federal Reserve’s trade-weighted average, you get the exchange rate. In essence, the exchange rate gives you the percentage of under- or overvaluation of a currency. The exchange rate adjusts so that the same good in two different countries will be the same price when put in the same currency. As we all know, just because it’s in a book or taught in a classroom, it doesn’t mean that it will happen in real life. Research shows that in the short-term you’ll never reach parity because of an insufficient time duration. Over the long-term, parity may never be reached because of things like Central Banks purposefully undervaluing their currency. Think of China. It’s an export dependent nation and undervaluing the currency also allows them to earn more in foreign reserves. With more emerging markets increasing prominence on the world scene, you’ll see more of this so they may be more competitive in the world market. And there are so many other differences that go into prices If only it was this simple to figure out what’s going on in different currencies. And that’s why the Big Mac Index is always talked about in a tongue-in-cheek manner. 38 | P a g e
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Look at all the different factors that could go into pricing that would differ from country to country:
The trade-weighted average can remain constant over a long period of time. The prices of a Big Mac are market driven. If this is the case, then the Index becomes severely flawed.
The prices of Big Macs may fluctuate throughout individual countries.
Different taxation systems could affect how the same product is priced. This would especially be the case in countries that have implemented value-added taxation systems.
Inflation varies between countries.
Different countries will pay different costs for goods and commodities. This will skew the Index.
The price of labor and possible trade restrictions between countries will also skew the Big Mac Index over the long-term.
Cultural or religious reasons will affect how Big Macs are received in different countries. Along those lines, there may be sharp differences in countries dependent upon its make-up of rural and urban areas.
And finally, we could discuss countries experiencing financial crisis or in the midst of military conflict.
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CHAPTER 10 OVERVIEW THE Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalize the prices of an identical basket of goods and services (in this case, a burger) in any two countries. For example, the average price of a Big Mac in America in July 2014 was $4.80; in China it was only $2.73 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 43% at that time. Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible. Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. For those who take their fast food more seriously, we have also calculated a gourmet version of the index.
This adjusted index addresses the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. The adjusted index uses the “line of best fit” between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country, given
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its income per person, and its actual price gives a supersized measure of currency under- and over-valuation The Big Mac index was introduced in The Economist in September 1986 by Pam Woodall as a semi-humorous illustration of PPP and has been published by that paper annually since then. The index also gave rise to the word burgernomics. UBS Wealth Management Research has expanded the idea of the Big Mac index to include the amount of time that an average worker in a given country must work to earn enough to buy a Big Mac. The working-time based Big Mac index might give a more realistic view of the purchasing power of the average worker, as it takes into account more factors, such as local wages. One suggested method of predicting exchange rate movements is that the rate between two currencies should naturally adjust so that a sample basket of goods and services should cost the same in both currencies. In the Big Mac Index, the basket in question is a single Big Mac burger as sold by the McDonald's fast food restaurant chain. The Big Mac was chosen because it is available to a common specification in many countries around the world as local McDonald's franchisees at least in theory have significant responsibility for negotiating input prices. For these reasons, the index enables a comparison between many countries' currencies. The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency). This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued. 41 | P a g e
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For example, using figures in July 2008 1. the price of a Big Mac was $3.57 in the United States (varies by store) 2. the price of a Big Mac was £2.29 in the United Kingdom (varies by region) 3. the implied purchasing power parity was $1.56 to £1, that is $3.57/£2.29 = 1.56 4. this compares with an actual exchange rate of $2.00 to £1 at the time 5. (2.00-1.56)/1.56 = 28% 6. the pound was thus overvalued against the dollar by 28% The Eurozone is mixed, as prices differ widely in the EU area. As of April 2009, the Big Mac is trading in Germany at €2.99, which translates into US$3.96, which would imply that the euro is slightly trading above the PPP, with the difference being 10.9%.
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CHAPTER 11 CONCLUSION Well, a hamburger may be able to tell you a little about the global economy. Better yet, it’s a way to look at similar countries with similar economies. I just mentioned all the differences that can affect the Index. Yet it may tell you some things if you compare countries with similar make-up and development. It can be a means to gauge changes in worker wages/productivity globally and to see if currencies are where they should be. “When you look at a country like India or Mexico, labor there is much cheaper than it is in the U.S. or in Europe. And that really has to do with productivity differences…so one thing we’re measuring is productivity gaps between different countries and how far along these places are in terms of development and growth with the richest countries.” And in turn, you could measure the difference between Big Macs in the U.S. and Switzerland. An inflated price for Big Macs in Switzerland may indicate that the franc is overvalued and will need to adjust. But above all remember, this was created in fun and is still used in that manner by The Economist. But there is some value in being able to identify issues that could be explained with more due diligence in the currency world.
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CHAPTER 12 REFERNCES
BIBLIOGRAPHY:
I.
The Big Mac Index- Application Of Purchasing Power ParityBy Li Lian Ong.
II.
Foreign Exchange Market- By Rushbh Production.
WEBLIOGRAPHY: I. II.
www.economist.com www.statista.com
III.
www.bigmacindex.org
IV.
www.nationmaster.com
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