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THE BIG MAC INDEX AND PURCHASING POWER PARITY

Purchasing power parity says that a basket of goods between two countries should cost the same when measured in a common currency. For example a basket of goods in the USA when converted in rand terms should cost the same as a similar basket of goods in South Africa. If the two baskets do cost the same then trade between the two countries will take place until prices have adjusted to make the two baskets cost the same.

Since 1986 The Economist has published yearly the prices of a Big Mac (the hamburger) in different countries and used these prices to calculate the purchasing power parity for each country. The purchasing power parity is measured relative to the US. From 1996 South Africa has been included in the survey. In the table the prices of a Big Mac in South Africa (measured in rand) and the US (measured in dollar) are given. The purchasing power parity value of the rand is calculated and this is compared to the actual value of the rand.

To calculate the purchasing power parity value of the rand, the price of a Big Mac in South Africa is divided by the price of a Big Mac in the US. For 2003 (the survey is always done in April) the purchasing power parity value of the rand was calculated as 5.15. This is the exchange rate that will ensure that the price of a Big Mac in the two countries are the same. The actual value of the rand at that stage was R7.56 per dollar and at that rate the rand was undervalued by 32% against the dollar. The rand purchases 32% fewer dollars than the purchasing power parity value indicates.

Over the whole period the rand was undervalued when measured against the US dollar. The extent of the undervaluation narrowed appreciably between 2002 and 2003 and is expected to have narrowed further when the next survey is done in April 2004.

One of the problems with this type of analysis is that a large share of the cost of a Big Mac is on non-tradeable goods. Ong (1997), quoted in Pakko and Pollard estimated that 94% of the cost of a Big Mac is sourced from non-traded goods (mainly wages and rent).

Balassa (1964) and Samuelson (1964), who are quoted in Pakko and Pollard, found that high income countries tend to have overvalued currencies. The reason for this is that productivity in the goods sector in high income countries are much higher than in low income countries. This higher level of productivity in the goods sector place upward pressure on all wages and if a product has a large non-traded component this will be reflected in higher prices for the product. The price of a Big Mac in Switzerland must be higher than the price of a Big Mac in Indonesia because the worker at Big Mac in Switzerland gets a wage that is related to wages in the  goods sector in Switzerland , that is much more productive than the goods sector in Indonesia. There therefore has to be made an adjustment in the levels of under- and overvaluation to reflect differences in productivity between countries. The graph shows the relationship between the deviation from purchasing power parity and wages (data provided in Pakko and Pollard is used in the analysis). A significant part of the deviation can be explained by productivity differences (which is reflected in wage rates). Each diamond on the graph shows the combination of a country's deviation from purchasing power parity and its wage in $. The regression line shows the statistical relationship between the deviation and the wage.

To get and adjusted under- or overvaluation it is necessary to calculate that part of the deviation that can be explained by productivity differences. In the case of South Africa the rand is undervalued by 32% against the dollar. By using the relationship shown in the graph (the regression line) the rand should be undervalued by 28%. The difference between 32% and 28% measures the adjusted deviation of the of its purchasing power parity. According to this measurement the rand is undervalued by 4% from its April 2003 level. This will give a purchasing power parity value of the rand of R7.26 per dollar instead of the crude purchasing power parity value of R5.15 per dollar.

The rand at current levels relative to the adjusted purchasing power parity level is overvalued.

Last updated 19 December 2003

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