Big Macs and BMI – getting the measure of our economic health

Watch  your  BMI,  London’s  The Economist  advised last week as it updated  its  Big Mac index—what it  calls its lighthearted  guide  to  currency  valuation.

For  NZ   this has  special  meaning,  because  since  January  the  NZ   dollar  has  moved  from  being  17%    to   23%  undervalued, according to the  BMI.

The Big Mac index, invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level, is based on the theory of purchasing-power parity (PPP). 

This is the notion that – in the long run – exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries.

A Big Mac costs NZ$6.20 in NZ and US$5.51 in the US. The implied exchange rate is 1.13. The difference between this and the actual exchange rate, 1.46, suggests the NZ dollar is 23.2% undervalued.

By comparison in January  the  Big  Mac  was worth  $6.20 in  NZ and  $5.28 in the US. The implied  exchange rate then  was  1.17.  The difference between this and the actual exchange rate was 1.37,  suggesting the  NZ  dollar  was  16.6%  undervalued.

In the  latest   update,   NZ  is  in  good  company,  with  Singapore’s   currency 23%    and  the  UK pound, similarly at  23%,  undervalued.

Since  the  January  BMI   NZ’s  currency has moved down  more sharply than in Singapore and the UK, but the  downward    swing has  not  been as great   as for the Argentinian peso   which slid  from  25%    to  51%  undervalued.

The Economist also publishes a GDP-adjusted index to address the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower.

PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today’s equilibrium rate.

The relationship between prices and GDP per person may be a better guide to the current fair value of a currency, The Economist says.

On this measure the NZ dollar is 9.9% undervalued, whereas Britain’s pound is 8.4% undervalued and Singapore’s currency is 21.2% undervalued.

The Economist says burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible

The need to understand the theory and set the right economic policy settings is important.

As a noted international economist once  said: “Since the exchange rate is the most powerful policy instrument with which to provide incentives for exporters, its maintenance at realistic levels which provide an incentive to producers to export is crucial to success”.

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