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]..............