See for Yourself CaseTaking a Bite Out of Purchasing Power Parity with the Big Mac IndexIn 1986, Pam Woodall introduced the Big Mac Index as an illustration of purchasing power parity (PPP), which is the theory that currencieswill go up or down in value to keep their purchasing power consistent across countries. Initially a lighthearted guide to whethercurrencies are at their "correct" level, the Big Mac Index has grown into a global standard and is now featured in many economictextbooks and dozens of academic studies. Many refer to this as "Burgernomics."The Big Mac Index is based on the theory of PPP that says, in the long run, exchange rates should move toward the rate that would equalize the pricesof an identical basket of goods and services in any two countries. This means that the price of an item in one currency should be the same price in anyother currency, adjusted for that currency's exchange rate. The Big Mac Index was never intended as a precise gauge of currency misalignment butrather a tool to make the theory surrounding exchange rates easier to understand. McDonald's was chosen because it is sold in 140 countries and isfamiliar to those trying to understand PPP.Twice a year, The Economist sends out people to purchase Big Macs all over the world. They then convert the prices paid in each country into Page 505dollars, and the index can show whether the currency is under- or overvalued. For example, if the United States and Mexico have PPP, then aBig Mac that is $3 in the United States would be roughly 55 pesos in Mexico. However, if the price in Mexico is higher, it would mean the peso isovervalued and Mexico has more purchasing power than the United States. Or, if the Big Mac in Mexico was priced lower, then the peso would beundervalued and Mexico would have less purchasing power than the United States.The index concept has been used with Apple's iPad mini and IKEA's BILLY bookcase. Users of the Big Mac Index should be wary of the limitations ofPPP. Issues include the idea that the price of a Big Mac will be dependent on local production, transportation costs, and promotion costs and that theremay be price variation based on geographic location (e.g., city versus rural area). Other issues not taken into account in the PPP include governmentintervention (taxes and tariffs), market competition (monopolies), and inflation. It has been said that the GDP-adjusted index better addresses the issuesthat affect the PPP and may be a better guide to the current fair value of a currency. Despite its limitations, the PPP still serves its purpose every year byproviding a quick and easy measure of currency values. Users should not rely too heavily on its calculations and should always investigate further.14Critical Thinking Questions1. What is purchasing power parity?2. Why is a McDonald's Big Mac used to create the index?3. What are the limitations of the Big Mac Index?ŷ

Question

See for Yourself CaseTaking a Bite Out of Purchasing Power Parity with the Big Mac IndexIn 1986, Pam Woodall introduced the Big Mac Index as an illustration of purchasing power parity (PPP), which is the theory that currencieswill go up or down in value to keep their purchasing power consistent across countries. Initially a lighthearted guide to whethercurrencies are at their &#34;correct&#34; level, the Big Mac Index has grown into a global standard and is now featured in many economictextbooks and dozens of academic studies. Many refer to this as &#34;Burgernomics.&#34;The Big Mac Index is based on the theory of PPP that says, in the long run, exchange rates should move toward the rate that would equalize the pricesof an identical basket of goods and services in any two countries. This means that the price of an item in one currency should be the same price in anyother currency, adjusted for that currency's exchange rate. The Big Mac Index was never intended as a precise gauge of currency misalignment butrather a tool to make the theory surrounding exchange rates easier to understand. McDonald's was chosen because it is sold in 140 countries and isfamiliar to those trying to understand PPP.Twice a year, The Economist sends out people to purchase Big Macs all over the world. They then convert the prices paid in each country into Page 505dollars, and the index can show whether the currency is under- or overvalued. For example, if the United States and Mexico have PPP, then aBig Mac that is $3 in the United States would be roughly 55 pesos in Mexico. However, if the price in Mexico is higher, it would mean the peso isovervalued and Mexico has more purchasing power than the United States. Or, if the Big Mac in Mexico was priced lower, then the peso would beundervalued and Mexico would have less purchasing power than the United States.The index concept has been used with Apple's iPad mini and IKEA's BILLY bookcase. Users of the Big Mac Index should be wary of the limitations ofPPP. Issues include the idea that the price of a Big Mac will be dependent on local production, transportation costs, and promotion costs and that theremay be price variation based on geographic location (e.g., city versus rural area). Other issues not taken into account in the PPP include governmentintervention (taxes and tariffs), market competition (monopolies), and inflation. It has been said that the GDP-adjusted index better addresses the issuesthat affect the PPP and may be a better guide to the current fair value of a currency. Despite its limitations, the PPP still serves its purpose every year byproviding a quick and easy measure of currency values. Users should not rely too heavily on its calculations and should always investigate further.14Critical Thinking Questions1. What is purchasing power parity?2. Why is a McDonald's Big Mac used to create the index?3. What are the limitations of the Big Mac Index?ŷ

Accepted Answer

The Consumer Price Index (CPI) is a measure of inflation that tracks the average change in prices of…

1. What is purchasing power parity? 2. Why is a McDonald's Big Mac used to create the index? 3. What are the limitations of the Big Mac Index?