Economists have come up with many ways to explain the power of a currency over time, from GDP measurements to relative purchasing power indices. One of the most popular measures of currency strength is the Big Mac Index. The Big Mac Index measures the relative purchasing power of a currency over time by comparing the cost of a McDonalds Big Mac in different countries. It illustrates how inflation can affect the power of a currency across international markets. In this article, we will explore what inflation means for the Big Mac Index and how it affects the relative purchasing power of a currency over time.
What Is Inflation?
Inflation is an economic term used to describe an increase in the overall price level of goods and services over a period of time. Inflation is caused by an ever-increasing money supply, while the output of goods remains constant, leading to an increase in prices over time. The Federal Reserve’s measure of inflation, the personal consumption expenditures price index (PCEPI) is the most widely used measure for inflation in the United States. The PCEPI is calculated by taking the average change in the price of goods and services purchased by consumers over the last 12 months. When the PCEPI grows, it is a sign of inflation, meaning that the purchasing power of money is weakening over time.
What Is the Big Mac Index?
The Big Mac Index is an informal measure of purchasing power parity (PPP). PPP is an economic theory that is used to explain the relative value of currencies. The theory states that the purchasing power of a currency should remain equal across countries and that the exchange rate between two currencies should equal the ratio of the prices of a basket of goods between the two countries. The Big Mac Index uses McDonald’s Big Mac sandwich as its basket of goods, comparing the cost of a Big Mac in different countries and adjusting for the exchange rate. By comparing the prices of a Big Mac between countries, the Big Mac Index can give an estimate of the purchasing power parity of two currencies.
How Does Inflation Affect the Big Mac Index?
Inflation affects the Big Mac Index in two ways. Firstly, inflation leads to an increase in the price of a Big Mac in each country, meaning that the prices of a Big Mac can become different despite having the same currency or exchange rate. When inflation affects one currency more than another, it can lead to a divergence in the prices of a Big Mac in different countries, which will lead to an inaccurate assessment of their relative purchasing power.
Secondly, inflation changes the exchange rate between two currencies, meaning that the Big Mac Index must be recalculated to take into account the new exchange rate. When the exchange rate changes due to inflation, it can lead to a significant change in the relative purchasing power of a currency over time, which is not accurately represented in the Big Mac Index.
The Big Mac Index is a popular measure of currency strength, but it is not adjusted for inflation. Inflation affects the Big Mac Index in two ways; an increase in the price of a Big Mac due to inflation, and a change in the exchange rate due to inflation. Both of these factors can lead to an inaccurate assessment of the relative purchasing power of a currency over time. Therefore, it is important to take into account inflation in order to accurately measure the relative power of a currency over time.
