Which is true about the Big Mac Index?

Question

BlackTom AI · Accepted Answer

The Big Mac Index can indicate whether a currency is under‑ or over‑valued because it compares the local price of a standardized good (a Big Mac) across countries to determine an implied purchasing‑power‑parity (PPP) exchange rate.

1) Relevant knowledge points and concepts
- Law of One Price: identical goods should sell for the same price when priced in a common currency, absent trade frictions.
- Purchasing Power Parity (PPP): exchange rates should adjust so that a basket of goods costs the same across countries.
- Big Mac Index: an informal PPP measure using one standardized consumer good (the Big Mac) sold in many countries.

2) Step‑by‑step reasoning
- Take the price of a Big Mac in the U.S. (P_US) and in a foreign country in local currency (P_F).
- Compute the implied PPP exchange rate: e* = P_US / P_F (units: USD per unit of foreign currency).
- Compare e* to the actual market exchange rate e (USD per unit of foreign currency).
- If e < e*, the foreign currency is undervalued (it buys fewer USD than implied by PPP). If e > e*, it is overvalued.

3) Example calculation (intermediate steps)
- Suppose P_US = $5.00 and P_UK = £3.00.
- Implied PPP e* = 5.00 / 3.00 = $1.6667 per £.
- If the market exchange rate e = $1.30 per £, then percent undervaluation ≈ (1.6667 − 1.30) / 1.6667 ≈ 22%.
- Conclusion: the pound is undervalued by about 22% relative to the dollar using this index.

4) Why the correct answer is correct
- The index directly yields an implied PPP exchange rate and thus signals whether a currency trades above or below that implied value, indicating under‑ or over‑valuation.

5) Why the other options are incorrect
- "All of these": false because not all listed statements are true.
- "Fully satisfies the assumptions necessary to apply the law of one price": false; the Big Mac is affected by local costs, taxes, non‑tradable services and market segmentation, so the Law of One Price does not fully hold.
- "It uses a basket of goods which is found in most countries": false; the Big Mac Index uses a single standardized good, not a broad basket.

Conclusion: therefore the correct choice is that the Big Mac Index can indicate whether a currency is under‑ or over‑valued, which matches the provided answer.

Which is true about the Big Mac Index?Single choice

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