The Big Mac Index was introduced in The Economist in September 1986 by Pam Woodall as a semi-humorous illustration and has been published by that paper annually since then. The index also gave rise to the word burgernomics .
Burgernomics is based on the theory of purchasing-power parity (PPP). This argues that the exchange rate between two currencies should in the long run move towards the rate that equalises the prices of identical bundles of traded goods and services in each country. In other words, a dollar should buy the same amount everywhere.
Our "bundle" is a McDonald's Big Mac, which is produced to more or less the same recipe in about 120 countries. The Big Mac PPP is the exchange rate that would leave hamburgers costing the same in each country.
The Big Mac was chosen because it is available to a common specification in many countries around the world, with local McDonald's franchisees having significant responsibility for negotiating input prices. For these reasons, the index enables a comparison between many countries' currencies.
The Big Mac PPP exchange rate between two countries is obtained by dividing the price of a Big Mac in one country (in its currency) by the price of a Big Mac in another country (in its currency).
This value is then compared with the actual exchange rate; if it is lower, then the first currency is under-valued (according to PPP theory) compared with the second, and conversely, if it is higher, then the first currency is over-valued.
Suppose the burger sells for 1.2 euros in Germany.
That would mean it costs 20 percent more in the euro area, suggesting that the euro is 20 percent overvalued relative to the dollar.
If the real exchange rate is out of sync, as it is when the cost is 1.2, there will be pressure on the nominal exchange rate to adjust, because the same good can be purchased more cheaply in one country than in the other.
It would make economic sense to buy dollars, use them to buy Big Macs in the United States at the equivalent of 1 euro, and sell them in Germany for 1.2 euros.
Taking advantage of such price differentials is called arbitrage .
As arbitrageurs buy dollars to purchase Big Macs to sell in Germany, demand for dollars will rise, as will its nominal exchange rate, until the price in Germany and the United States is the same—the RER returns to 1.
The burger methodology has limitations in its estimates of the PPP.
In many countries, eating at international fast-food chain restaurants such as McDonald's is relatively expensive in comparison to eating at a local restaurant.
Moreover, the demand for Big Macs is not as large in countries like India as in the United States.
Social status of eating at fast food restaurants like McDonald's, local taxes, levels of competition, and import duties on selected items may not be representative of the country's economy as a whole.
In addition, there is no theoretical reason why non-tradable goods and services such as property costs should be equal in different countries: this is the theoretical reason for PPPs being different from market exchange rates over time.
Nevertheless, economists widely cite the Big Mac Index as a real world measurement of purchasing power parity.