Our analysis focuses on four major currencies other than the dollar: the euro, the yen, the yuan and the pound
. It is a way to make exchange-rate theory more digestible. The index is based on purchasing-power parity : we take the real price of McDonald’s flagship burger around the world and compare it with what the price should be, based on the current exchange rate. In theory,signals where exchange rates should be heading in the long run—moving towards the rate that would make the price in dollars of a Big Mac the same in various countries.
If our Big Mac guide were fully in sync with future forex movements, a reading of 20 on the index would suggest that a currency is overvalued by 20% relative to the dollar, implicitly predicting it should decline by roughly 20% to be at fair value. In practice, the Big Mac index does not have such a perfect crystal ball . Its predictive power in the short term is especially weak. But it has a decent record over a five-year horizon .
Our chart shows how closely an index rating in every January since 2000 correlated with changes in real effective exchange rates one and five years later . . Burger prices do not strongly relate to currency movements at the one-year mark. But the index does provide an informative signal about their real exchange rates in five years’ time.
To see what that could mean for future exchange rates, consider the current index readings. If a Big Mac costs $5.36 in America, by today’s exchange rate it should cost £4.34 in Britain. In fact, the meal costs £3.79, or $4.68. That suggests that the pound is undervalued against the dollar by about 13%. The pound tanked last year, after a
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