Big Macs, Price Differentials, and Single Currency Areas

I fortuitously came across this while looking at something else:

What does the Big Mac say about Euro Area adjustment?

The Big Mac Index offers some quick insights into the state of currencies around the globe by comparing the price of Big Macs across countries. Of course, the Big Mac index was never intended as a precise gauge of currency misalignment, as the Economist has just reminded us in its latest update. According to them, it is just about making PPP and other difficult exchange rate concepts more digestible.

Well, in the euro area, we have the euro to be able to simply compare prices across the euro area. So how have Burger prices moved recently? Are prices in the euro area adjusting? Should we be pessimists or optimists on the adjustment challenge in the euro area? Since July 2011, the Economist has also been collecting the individual prices of Big Macs in major euro area countries...

...the Big Mac tells us that Italy is the most expensive place in the euro area. A Big Mac costs €3.85, while it costs only €3.6 in France and 3.64 in Germany. Or to put it in percentages, in July 2011, Italy was overvalued by 2.9% while in January 2013, it was overvalued by 5.7% relative to Germany. Of course, you may just as well say that Germany was undervalued… but then, the adjustment in Germany seems to go in the right direction but not in Italy in these last one and a half years…

…Overall, the Big Mac index shows some adjustment in the euro area in the last 18 months but Italian inflation rates are worrying. Labour market reforms that do not translate into lower product market prices are detrimental to consumers and prevent the economy from gaining export strength. Italy needs to apply the right policies to address high inflation.

A lot of people use the Big Mac index as a barometer for currency over- or under-valuation. But the fact that you can have significant price differences within a single currency area suggests this approach is bogus – how can the same currency be over- AND under-valued at the very same time? We’re not talking about small differences either – there’s a full one Euro price gap (30% of the average price) between Italy (the most expensive) and Estonia (the cheapest).

For that matter, there are and remain differences in pricing even within a single country like Malaysia – most items are more expensive in East Malaysia than it is in the Peninsular for instance, largely due to higher transportation costs.

Bottom line: the Big Mac index is pretty good at delineating price and purchasing power differences between countries. Just don’t use it as a guide to currency misalignments.

An update to the post is available here.