Purchasing Power Parity (PPP) and the Big Mac Index

Purchasing Power Parity (PPP) is the theory that 'the exchange rate ultimately adjusts to the purchasing power of the two countries' currencies.' Underlying it is the 'law of one price.' The idea is that the same good, bought in any country, should cost about the same (once converted through the exchange rate).

For example, if a good costing $1 in the U.S. costs 1,300 won in Korea, then the 'appropriate exchange rate' is 1,300 won per dollar. If the actual exchange rate is higher or lower than this, you interpret one currency as 'overvalued' or 'undervalued.'

PPP isn't a tool for getting short-term exchange rates right. The exchange rate swings daily due to factors like interest rates, trade, and sentiment. Rather, it's closer to a compass that tells you 'the rough reference point the exchange rate heads toward over the long run.'

What the British magazine 'The Economist' created in September 1986 to show PPP in a fun way is exactly the Big Mac Index. The idea is that since Big Macs are sold at McDonald's worldwide with similar ingredients and recipes, they're good for comparing prices by country.

The calculation is simple.

① Check each country's Big Mac price in that country's currency.

② 'Implied exchange rate' = (that country's Big Mac price) ÷ (the U.S. Big Mac price).

③ Compare this implied exchange rate with the actual market rate.

For example, in July 2023, a Swiss Big Mac was 6.70 francs and the U.S. one was $5.58. The implied exchange rate was 6.70 ÷ 5.58 = about 1.20 francs/dollar, but the actual rate was 0.87 francs/dollar. In other words, since the actual franc was more expensive than the calculated value, the Swiss franc was seen as about 38% 'overvalued.'

As of January 2025, the average U.S. Big Mac price was about $5.79. In the same period a Korean Big Mac (single item) was 5,500 won and the exchange rate was about 1,431 won per dollar, so converted to dollars it was about $3.84.

Korea ($3.84) was about 66% of the U.S. level ($5.79). The Economist interpreted this as 'the won is about 33.6% undervalued against the dollar.' At the time, Korea's Big Mac Index had fallen to a record-low level.

Looking at other countries around the same time, the Taiwan, Indonesia, India, and Japan currencies came out roughly 50–60% undervalued, while the Swiss and Norway currencies came out overvalued. Currencies of lower-income countries coming out undervalued is also a natural feature of the Big Mac Index.

The Big Mac Index has clear limits, so much so that The Economist itself calls it 'half a joke.'

First, a Big Mac's price mixes in not only ingredient costs but 'non-traded costs' like rent and labor. In countries with cheap labor, Big Macs come out cheap too, so the currency easily looks more undervalued than it actually is.

Second, Big Mac specs, sizes, and local strategies differ slightly by country, so it isn't a perfectly identical good.

Third, countries without McDonald's can't be compared at all.

So it's right to view the Big Mac Index not as an 'accurate appropriate exchange rate' but as an educational tool for intuitively understanding exchange rates and prices. Still, it's quite useful for getting a feel for whether a currency is cheap or expensive.

When you invest in overseas stocks or a U.S. index, the return depends on two things: how much the asset price rose, and how the exchange rate moved.

If you buy dollar assets when the won is undervalued (= the dollar is expensive), you can suffer an FX loss later when the won returns to normal. Conversely, if the exchange rate moves favorably, the won-converted return on the same asset grows larger.

PPP is a reference framework for gauging 'whether the exchange rate is expensive or cheap by historical standards right now.' Of course, trying to time with it is dangerous. The exchange rate moves away from PPP for years at a time. Instead, the key is to remember the fact that 'my overseas investment return comes bundled with the variable of the exchange rate.'

'The Return of Almost Everything' is a site I built myself to show these FX effects together, without hiding them. You can directly compare how the return on the same asset differs on a won basis versus a local-currency basis.