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The Big Mac Index is a means to understand how parity of purchase power (PPP) works. It was published first time by The Economist magazine in 1986 aiming to show how under or overvalued is a foreign currency compared with US Dollar using the Macdonald’s flag menu that is sold in 119 around the world, to make the explanation easier to get to readers. Despite of being an informal index, it became in a global standard and it’s also used in many scholar textbooks.
The Big Mac Index take the prices of each Big Mac in it respective currency and then divides both prices, local divided by foreign obtaining the Big Mac exchange rate, if the price in dollars is more than actual exchange rate so that means the local currency is overvalued, the contrary if it’s lower than exchange rates in such case the currency is undervalued.
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But what does mean a currency is overvalued? Does that mean such country has better economic situation? With the current example we could deduce it, Swiss franc is worth than dollar; but not necessarily, for example: UK Pound was 9% undervalued in 2011 while Brazilian Real was 35% overvalued according to Big Max Index from such year. In fact, an overvaluation implies the currency is too high for actual state of economy, making exports and domestic goods expensive with regard to international trade, it causes, in consequences, foreign goods become more attractive to consumer raising imports and declining domestic demand.
If we based on PPP theory, a situation of overvaluation or undervaluation would cause prices adjust until local currency and foreign can buy the same basket of goods equal in long term, however this is also tied to another factors such taxes, inflation, etc; making the parity hard to reach.
Despite Big Mac Index is useful to make us an idea of the situation of a country respect to international trade, we should remember is just a little guide that doesn’t any scientific purpose and it's subject to much variables making it target of some criticism, some of them:
''1)In many countries, dining at McDonald’s is relatively expensive when compared to dining at a local restaurant. Hence, the demand for a burger is relatively less. Hence, it doesn’t stand as globally acceptable.
2)The total price of a Big Mac burger will be dependent upon the local production, delivery cost, advertising costs, transportation costs and the status of the local market, which will be different among countries and not be a reflection of overall relative currency values.
3)The high volume and low margin approach determines the profit range in many markets and in some, high margin approach maximizes the profit. Hence, the value determined will not reflect the fair currency status.
4)The prices of Big Mac also vary with the areas in which it is sold. Therefore, a Big Mac sold in a major city might be more expensive than one sold in a somewhat rural area.''
Corporate Finance Institute