The Economist‘s Big Mac index is based on one of the oldest concepts in international economics: the theory of purchasing-power parity (PPP), which argues that in the long run, exchange rates should move towards levels that would equalise the prices of an identical basket of goods and services in any two countries. Our “basket” is a McDonald’s Big Mac, produced in around 120 countries. The Big Mac PPP is the exchange rate that would leave burgers costing the same in America as elsewhere. Thus a Big Mac in China costs 10.5 yuan, against an average price in four American cities of $3.10 (see the first column of the table). To make the two prices equal would require an exchange rate of 3.39 yuan to the dollar, compared with a market rate of 8.03. In other words, the yuan is 58% “undervalued” against the dollar. To put it another way, converted into dollars at market rates the Chinese burger is the cheapest in the table.

http://www.economist.com/finance/displaystory.cfm?story_id=6972477

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