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Big Mac Index: An Exchange Rate Exercise

CASELET, MANAGERIAL ECONOMICS
ET Cases, 5 pages

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Big Mac Index: An Exchange Rate Exercise

 

The Economist’s Hamburger Standard (popularly known as The Big Mac Index) appeared in its print edition which appeared on April 21st 2001, page 74 (Exhibit I). A few related questions have been framed to connect the dots between exchange rates, Purchasing Power Parity (PPP) theory and The Big Mac Index. Each of the questions is meant to illustrate when a currency is overvalued and when a currency is undervalued.

I. Exchange Rates and Exchange Rate Determination: The Basics

1. What do you understand by exchange rate? How is exchange rate determined?
2. What do you mean by currency appreciation and what do you think are the factors for the same?
3. What do you understand by currency depreciation? List the factors influencing currency depreciation.

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Teaching Note Preview

Big Mac Index: An Exchange Rate Exercise

 

Synopsis

This caselet is based on The Economist’s Hamburger Standard (April 21st 2001). Popularly known as Big Mac Index, it was first introduced in 1986 by The  Economist, the name derived from Big Mac, a hamburger sold at McDonald’s. According to the index, the exchange rates between two currencies should naturally adjust, so that a sample basket of goods and services should cost the same for both currencies. The ‘basket of goods’ used in this index is a Big Mac hamburger, which is available around the world and used to measure the Purchasing Power Parity (PPP) in about 120 countries. Thus, the Big Mac Index is used as a yardstick to identify if a currency is expensive or cheap. However, it was never intended as a precise gauge of currency misalignment, but merely a tool to simplify the exchange-rate theory.

The caselet introduces the participants/students to the concept and relevance of Big Mac Index. How does Big Mac Index help in understanding whether a currency is overvalued or undervalued? What would be the impact of inflation and higher real interest rates on the exchange rate? What is implied by PPP Exchange Rate?

Prerequisite Conceptual Understanding/Before the Classroom Discussion

The participants should be asked to read the following chapter to help them connect the concepts discussed in the caselet:

  • • Paul A. Samuelson, et al., “Exchange Rates and the International Financial System”, Economics, 19th Edition (Special Indian Edition), McGraw Hill Education (India) Private Limited, 2014 – To understand the concepts of foreign exchange, exchange rates, Purchasing Power Parity (PPP), appreciation and depreciation of currency and devaluation of currency

 

Case Positioning and Setting

The caselet can be used in MBA, Executive MBA or Executive Development Programs, for the following module/topic:

  • • Exchange Rates – To understand the concepts of foreign exchange, exchange rates and Purchasing Power Parity (PPP), Absolute PPP and Relative PPP, the Big Mac Index and overvaluation or undervaluation of a currency, inflation and interest rates and their impact on exchange rates

 

Preamble to the Caselet Analysis and Suggested Orchestration

Exchange Rate is an important economic agenda for a country’s macroeconomic management in general and monetary policy of the central bank in particular. With constant and rapid changes in internal economics, the exchange rate can become quite volatile if enough attention is not paid at the appropriate time. If a country’s currency is overvalued it can impact its export competitiveness. What happens if a country’s currency rate is undervalued? What would be the impact of inflation and higher real interest rates on exchange rates? To discuss these issues, this caselet was orchestrated in the classroom in the following manner [Exhibit (TN)-I]..............

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Product code: ME-2-0019, ME-2-0019A

Abstract


This caselet, based on The Economist's Hamburger Standard (April 21st 2001), introduces the participants/students to the concept and relevance of Big Mac Index. While the concept has been widely used in understanding whether a currency is overvalued or undervalued, its relevance has only been growing over the last three decades in the exchange rate discussions and deliberations. Introduced in 1986 by The Economist, Big Mac Index is based on the Theory of Purchasing Power Parity (PPP)/ Law Of One Price (LOOP). Also known popularly as 'Burgernomics' this concept has been largely intended to make exchange rate theory more meaningful and simple. In one sense, the Big Mac Index is an index to both external and internal macroeconomic policies of a country. The Big Mac Index is based on the premise that a dollar should buy the same amount in all countries. How does Big Mac Index help in understanding whether a currency is overvalued or undervalued? What would be the impact of inflation and higher real interest rates on the exchange rate? What is implied by PPP Exchange Rate?



Pedagogical Objectives

  • To understand the concept of Exchange Rate, Exchange Rate determination and discuss the importance of currency appreciation and/or currency depreciation for a country’s economic fortunes
  • To learn the concept of Purchasing Power Parity (PPP) Theory/The Law Of One Price (LOOP) and understand the two versions of PPP - Absolute PPP and Relative PPP
  • To understand the importance of Big Mac Index in interpreting exchange rates

Case Positioning and Setting

The caselet can be used in MBA, Executive MBA or Executive Development Programs, for the following module/topic:

  • Exchange Rates - To understand the concepts of foreign exchange, exchange rates and Purchasing Power Parity (PPP), Absolute PPP and Relative PPP, the Big Mac Index and overvaluation or undervaluation of a currency, inflation and interest rates and their impact on exchange rates




This Case Pack Includes:
- Abstract
- Caselet
- Teaching Note (**ONLY for Academicians)
$3.66
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