~ ) Pergamon J o u n t a l q f l n t e r n a t i o n a l Monca' a n d Finance Vol. 16. No. 6, pp. 865 878, 1997 © 19t~7 Elsevier Science Ltd. All rights rcservcd Printed in G r e a t Britain P I I : S0261-5606(97)00032-6 0 2 6 1 - 5 6 0 6 / 9 7 $17.00 + 0.00 Burgernomics: the economics of the Big Mac standard* L I L I A N O N G + Department of Accounting and Finance, The University of Western Australia, Nedlands, WA 6907, Australia In the course of PPP research, much o f the debate over the validity has been over the choice o f an a p p r o p r i a t e ' b a s k e t ' for making purchasing power comparisons. The different compositions of goods and services in these baskets across countries have resulted in arguments against their usefulness for PPP purposes. This problem is a u g m e n t e d by the existence o f productivity differentials in t r a d e d and non-traded goods across coun- tries. T h e r e f o r e we consider the use o f the Big Mac as the international monetary s t a n d a r d as being a more palatable alternative: It is p r o d u c e d locally in over 80 countries a r o u n d the world, with only minor changes in recipe and thus has the flavour of ' t h e perfect universal commodity'. O u r results indicate that the Big Mac Index is surprisingly accurate in tracking exchange rates over the long-term, which is consistent with previous PPP research findings. W e subsequently enhance our PPP comparisons by taking into account the productivity differentials between countries and excluding n o n - t r a d e d goods from the Big Mac Index to derive the No-Frills Index. ( J E L F31). © 1997 Elsevier Science Ltd. All rights reserved. 'Suppose a man climbs five f e e t up a sea wall, then climbs down 12 feet. Whether he drowns o r not depends u p o n how high above sea-level he was when he started. T h e same p r o b l e m arises in deciding whether currencies are under- or o v e r - v a l u e d . . . ' The Economist, 26 August 1995 (p. 70) The purchasing power parity (PPP) doctrine is perhaps o n e o f the oldest and most widely researched areas in international finance. The origins o f PPP theory can be traced back to Spanish scholars o f the sixteenth century, although the intellectual origins o f the doctrine are credited to Wheatley's and *This p a p e r is a revised version o f a section o f my PhD thesis at the University o f W e s t e r n Australia, jointly supervised by Professor H. Y. Izan and Professor K. W. Clements. I ' d also like to thank G e o f f Kingston, P e t e r Forsyth, M a r d i Dungey, James R. Lothian, the participants at the 1995 PhD Conference in Economics and Business and an anonymous referee for their helpful comments; and the Australian Agency for I n t e r n a t i o n a l D e v e l o p - ment ( A u s A I D ) , and the D e p a r t m e n t of Accounting and Finance, The University o f Western Australia for thei.

1. ~ ) Pergamon J o u n t a l q f l n t e r n a t i o n a l Monca' a n
d Finance Vol. 16. No. 6, pp. 865 878, 1997 © 19t~7 Elsevier
Science Ltd. All rights rcservcd
Printed in G r e a t Britain
P I I : S0261-5606(97)00032-6 0 2 6 1 - 5 6 0 6 / 9 7 $17.00 +
0.00
Burgernomics: the economics of the Big
Mac standard*
L I L I A N O N G +
Department of Accounting and Finance, The University of
Western
Australia, Nedlands, WA 6907, Australia
In the course of PPP research, much o f the debate over the
validity has
been over the choice o f an a p p r o p r i a t e ' b a s k e t ' for
making purchasing
power comparisons. The different compositions of goods and
services in
these baskets across countries have resulted in arguments
against their
usefulness for PPP purposes. This problem is a u g m e n t e d
by the existence
o f productivity differentials in t r a d e d and non-traded
goods across coun-
tries. T h e r e f o r e we consider the use o f the Big Mac as
the international
monetary s t a n d a r d as being a more palatable alternative: It

2. is p r o d u c e d
locally in over 80 countries a r o u n d the world, with only
minor changes in
recipe and thus has the flavour of ' t h e perfect universal
commodity'. O u r
results indicate that the Big Mac Index is surprisingly accurate
in tracking
exchange rates over the long-term, which is consistent with
previous PPP
research findings. W e subsequently enhance our PPP
comparisons by
taking into account the productivity differentials between
countries and
excluding n o n - t r a d e d goods from the Big Mac Index to
derive the No-Frills
Index. ( J E L F31). © 1997 Elsevier Science Ltd. All rights
reserved.
'Suppose a man climbs five f e e t up a sea wall, then climbs
down 12 feet.
Whether he drowns o r not depends u p o n how high above
sea-level he was
when he started. T h e same p r o b l e m arises in deciding
whether currencies
are under- or o v e r - v a l u e d . . . ' The Economist, 26
August 1995 (p. 70)
The purchasing power parity (PPP) doctrine is perhaps o n e o f
the oldest and
most widely researched areas in international finance. The
origins o f PPP
theory can be traced back to Spanish scholars o f the sixteenth
century,
although the intellectual origins o f the doctrine are credited to
Wheatley's and

3. *This p a p e r is a revised version o f a section o f my PhD
thesis at the University o f W e s t e r n
Australia, jointly supervised by Professor H. Y. Izan and
Professor K. W. Clements. I ' d also
like to thank G e o f f Kingston, P e t e r Forsyth, M a r d i
Dungey, James R. Lothian, the
participants at the 1995 PhD Conference in Economics and
Business and an anonymous
referee for their helpful comments; and the Australian Agency
for I n t e r n a t i o n a l D e v e l o p -
ment ( A u s A I D ) , and the D e p a r t m e n t of Accounting
and Finance, The University o f
Western Australia for their financial support. All remaining
errors in this p a p e r are mine.
*Corresponding author. Tel.: + 6 1 08 93803625; fax: +61 08
93801047; e-mail:
[email protected]
865
Burgemomics: the economics of the Big Mac standard: Li Lian
Ong
Ricardo's w o r k in the n i n e t e e n t h century. ~ PPP t h e o
r y as we know it today,
however, is attributed to Gustav Cassel's writings during the
1920s. This
interest has intensified over the last two decades with t h e
collapse o f t h e
B r e t t o n W o o d s system and the reintroduction o f
flexible exchange rates in t h e
early 1970s. 2 T h e controversial findings during this time
have resulted in some
researchers rejecting the merits of PPP in explaining exchange
rate move-

4. ments, while others c o n t e n d that PPP does i n d e e d
provide a strong basis for
exchange rate determination, with useful policy implications.
In t h e course o f PPP research, m u c h o f the debate over
its validity has b e e n
over t h e choice o f an appropriate 'basket' for making PPP
comparisons. T h e
different compositions of goods and services in these baskets
across countries
and the extent to which these items affect the exchange rates
have resulted in
arguments against their usefulness for PPP purposes. F r o o t
and R o g o f f (1994)
observe that most empirical tests do not a t t e m p t to c o m p
a r e identical baskets,
but instead use different countries' c o n s u m e r and
wholesale price indices
which consist o f different weights and mixes o f goods across
countries. This
m e a n s that even if PPP holds, it m a y not necessarily show
up in the results
unless the two countries in question have identical baskets.
Similarly, B e t t o n e t
al. (1995) argue that w h e n consumption bundles are not
identical, price indices
based on local consumption patterns m a y behave differently
even though the
law o f one price holds for each commodity, resulting in biased
outcomes o f
PPP tests. 3
A n o t h e r major limitation in PPP research has b e e n t h e
productivity bias
hypothesis (PBH), which is probably considered the most
serious criticism o f

5. the absolute PPP t h e o r y today. This hypothesis, first
introduced by H a r r o d
(1939) and subsequently formalised by Balassa (1964) and
Samuelson (1964), is
based on the premise that productivity growth in the tradeable
goods sector is
faster t h a n that in the non-tradeable goods sector. 4 T h e
result is that if t h e real
exchange rate b e t w e e n two countries is c o m p u t e d
using price deflators that
include both tradeable and non-tradeable goods, t h e n the
currency o f t h e
country with faster productivity growth in the t r a d e d sector
than in the
n o n - t r a d e d sector will be systematically overvalued
relative to its PPP level. 5
T h e U n i t e d Nations International Comparisons Project
(ICP) m e t h o d o f
accounting for PPP, which has received wide attention recently,
is also based
on the premise o f productivity differentials b e t w e e n
countries. 6 According to
Kravis (1986), this system o f international income and
purchasing p o w e r
comparisons improves t h e m e a s u r e m e n t o f countries'
average incomes and t h e
differences b e t w e e n them. Moreover, the ICP m e t h o d
also enables t h e compar-
ison o f price levels b e t w e e n countries and n o t just the
relative changes in
t h e m ] Using t h e ICP data, O h (1996) finds that PPP holds
in the long-run f o r
G-6 and O E C D countries u n d e r flexible exchange rates.
Given t h e prevailing index-number and productivity bias

6. problems, we have
d e c i d e d to use the Big Mac as the international m o n e t a r
y standard in this test
o f PPP, in place o f the traditional basket o f goods and
services. O u r decision is
based on the Big Mac being 'the perfect universal commodity'. 8
F u r t h e r m o r e ,
since t h e Big Mac comprises both t r a d e d and n o n - t r a
d e d goods, we are able to
incorporate the productivity bias concept into o u r research.
Pakko and Pollard
866
Burgernomics: the economics o f the Big Mac standard: Li Lian
Ong
(1996) provide an i n d e p e n d e n t analysis o f Big M a c
PPP. In that paper, the
authors investigate t h e p e r f o r m a n c e o f absolute and
relative Big M a c PPP.
T h e y also provide a discussion on why PPP fails. While we
also p e r f o r m tests o f
absolute and relative PPP similar to Pakko and Pollard's, we
extend the
analysis by (i) examining the productivity bias problem in g r e
a t e r detail using
the Big M a c h a m b u r g e r ; and (ii) improving on the Big
Mac Index by introduc-
ing the No-Frills Index, which takes into account the
productivity differentials
b e t w e e n countries.
T h e data used in this study consist of the prices o f M c D o n

7. a l d ' s Big M a c
hamburgers in 34 countries and the corresponding exchange
rates over t h e
1986-1994 period. These are published annually in The
Economist magazine.
O u r results indicate that the Big Mac Index performs just as
well as, if n o t
b e t t e r than, most indices used in tests of PPP. Like Pakko
and Pollard (1996),
we find that the Index is surprisingly accurate in tracking
exchange rates over
the long-term (i.e. t h e 9 years o f o u r sample period) which
is consistent with
previous PPP research findings. Even though individual
currencies m a y deviate
f r o m Big M a c PPP on a country-by-country basis, there is a
distinct t e n d e n c y
for deviations to offset o n e a n o t h e r so that the world
currencies, in aggregate,
are at parity for any 1 particular year. Moreover, geographic
influences a p p e a r
to play an important role in currency valuation. We show that
PPP compar-
isons can be e n h a n c e d by taking into account the
productivity differentials
b e t w e e n countries and excluding n o n - t r a d e d goods
from the Big Mac Index to
derive the No-Frills Index.
This p a p e r is organised as follows. Section I examines t h e
valuation o f
currencies relative to their Big Mac PPP. This is followed by f u
r t h e r tests o f
PPP using regression analysis in Section II. In Sections III and
IV, the Big Mac
is d e c o m p o s e d into its t r a d e d and n o n - t r a d e d c

8. o m p o n e n t s in o r d e r to e n h a n c e
PPP comparisons. W e conclude with a s u m m a r y o f o u r
findings in Section V.
I. T h e v a l u a t i o n o f c u r r e n c i e s
In this section, we investigate the valuation of currencies
relative to their Big
Mac PPP. Let Pc, be t h e domestic currency price o f a Big
Mac in c o u n t r y c in
y e a r t; P,* be the price in US dollars o f a Big Mac in the
US; and Sct be the
spot exchange rate, defined as the domestic currency cost o f
US$1. Accord-
ingly, P, JPt* is the Big M a c PPP. Expressed in logarithmic
form, we have
(1) log Pct/Pt* Pet rct==- ( Set ) = log~-t. - log Sct,
such that a currency is said to be overvalued if rot is g r e a t e r
t h a n zero,
undervalued if r,., is less than zero and at parity if r , equals
zero. T h e
p e r c e n t a g e deviation f r o m parity is approximately rct
X 100. Figure 1 shows the
country averages o f t h e o v e r / u n d e r - v a l u a t i o n s ,
rc., w h e r e t h e 'o' notation
indicates averages over time. Broadly speaking, it appears that t
h e high-growth,
developing economies in the A S E A N - O c e a n i a and E a s
t e r n E u r o p e a n regions
are generally u n d e r v a l u e d against the US, while the
currencies o f d e v e l o p e d
867

9. Burgernomics: the economics o f the Big Mac standard: Li Lian
Ong
rt. x 100
60
40
> 20 ©
-20
-40 >
60
-80
i l t I L l l i i i O i l l l O i O i O l O i O i O i l l i O i l l i O i O
i ~ i i i i i i ,
I I I
n
o,o
Grand Average
O , , ,, ,, ,, I
I
The Americas Western and Central Europe Eastern Europe East
Asia ASEAN-

10. Oceania
FIGURE 1. Over/under-valuation of currencies: regional groups,
1986-1994 averages.
r., x 100
35
30
25
o=
"~ 20
i ,5
o
10
0 .=
"~ -5
.g
-10
Grand Average
] ] ~ ' I I ' [ ] . . . . . [
1986 1987 119881 1989 1990 1991 1992 1993 1994
I I
FIGURE 2. Over/under-valuation of currencies: annual cross-

11. country averages, 1986-1994.
countries in Western and Central Europe, along with t h o s e o
f the highly
industrialised East A s i a n countries o f Taiwan, Japan and S
o u t h Korea, are
overvalued. 9 Figure 2 plots the annual averages o f the
deviations from parity
across countries, to,, where the ' . ' n o t a t i o n indicates
averages across countries.
A s can be seen, the U S dollar appears overvalued in 1988 and
1994, a l th o u g h
n o t by much in the latter year. The dollar appears undervalued
in all o t h e r
ye ars. 10
868
Burgernomics: the economics of the Big Mac standard." Li Lian
Ong
II. F u r t h e r tests o f Big M a c P P P
In Section I, we look at the valuation o f currencies relative to
their Big Mac
PPP and find that geographic influences play an important role
in currency
valuation. Furthermore, it appears that the U S dollar is
generally at parity on a
year-by-year basis. Using both time-series and averaged data,
we now conduct
regression-based tests to corroborate our results. Consider the
following rela-
tionship between the actual exchange rate in country c and year

12. t (Set) and the
corresponding price ratio Pet -= P c t / P t * :
( 2 ) log S a = o~ + / 3 log p ~ ,
where the PPP hypothesis implies a zero intercept term and a
unit slope
coefficient (o~= 0, / 3 = 1). The regression results are
presented in Table 1. II
Overall, Eq. ( 2 ) appears to model short-term PPP very well.
12 We subse-
TABLE 1. Regression results: exchange rates and prices
(standard errors in parentheses)
Year PPP M o d e l N u m b e r o f Intercept Slope A d j u s t
e d S.E.
observations R 2
I. Cross-country
1986 A b s o l u t e 14 0.124 (0.118) 0.915 (0.046) 0.968 0.318
1985/1986 Relative . . . . . . .
1987 A b s o l u t e 8 - 0 . 2 2 5 (0.087) 0.953 (0.026) 0.995
0.183
1986/1987 Relative 7 - 0 . 0 5 2 (0.012) 0.167 (0.080) 0.358
0.031
1988 A b s o l u t e 16 0.180 (0.116) 0.958 (0.035) 0.980 0.353
1987/1988 Relative 7 - 0 . 3 7 6 (0.207) - 0 . 6 5 3 (0.557)
0.058 0.044
1989 A b s o l u t e 17 - 0 . 0 1 0 (0.145) 0.991 (0.037) 0.978
0.427
1988/1989 Relative 16 - 0 . 2 6 3 (0.033) 1.635 (0.088) 0.958
0.093
1990 A b s o l u t e 18 - 0 . 0 1 4 (0.135) 0.953 (0.041) 0.969
0.422
1989/1990 Relative 17 0.002 (0.033) 1.075 (0.022) 0.993 0.132

13. 1991 A b s o l u t e 19 - 0 . 0 6 3 (0.128) 0.964 (0.039) 0.972
0.388
1990/1991 Relative 18 - 0 . 0 4 8 (0.033) 0.879 (0.115) 0.771
0.127
1992 A b s o l u t e 22 - 0 . 0 7 3 (0.154) 0.990 (0.042) 0.964
0.485
1991/1992 Relative 18 - 0 . 1 9 1 (0.083) 2.155 (0.184) 0.889
0.317
1993 A b s o l u t e 24 - 0 . 0 4 8 (0.112) 0.987 (0.029) 0.981
0.392
1992/1993 Relative 20 0.036 (0.026) 0.798 (0.030) 0.974 0.112
1994 A b s o l u t e 31 - 0 . 0 2 8 (0.103) 1.010 (0.025) 0.982
0.360
1993/1994 Relative 23 0.053 (0.022) 0.850 (0.025) 0.981 0.103
II. C r o s s - c o u n t r y / t i m e - s e r i e s
1986-1994 A b s o l u t e 169 - 0 . 0 1 7 (0.042) 0.981 (0.012)
0.977 0.388
Relative 126 0.002 (0.024) 1.000 (0.031) 0.896 0.272
III. Average over time
1986-1994 A b s o l u t e 34 - 0 . 0 1 8 (0.094) 1.001 (0.024)
0.982 0.347
Relative 26 0.003 (0.014) 1.127 (0.032) 0.980 0.073
869
Burgernomics: the economics o f the Big Mac standard: Li Lian
Ong
quently run the regression using country data averaged over
time, such that log

14. So° = o~ + / 3 log Pc.. T h e results suggest that P P P holds
as a long-run proposi-
tion. ~3
Previously, we e m p l o y e d P P P in terms of levels which is
also known as
absolute P P P . W e now e m p l o y the relative version of P
P P which is in first
differences, i.e. Alog Set = a ' + / 3 'Alog Pc,, w h e r e Pc~ =
P ~ J P * , as before. The
use o f first differences accounts for the proven I(1) p r o p e r
t y o f exchange
rates. ~4 As with the absolute P P P regressions, we estimate
the relative P P P
m o d e l for each year's d a t a as well as for the p o o l e d
data. W e also consider the
use o f averaged data. ~ O u r results from using p o o l e d
data s u p p o r t the use o f
Big M a c prices for making P P P comparisons. Thus, o u r
findings once again
show that Big M a c P P P holds over the long-term.
O u r findings to this point indicate that Big M a c P P P
generally holds for o u r
sample countries, b o t h on a year-by-year basis and averaged
over 9 years.
However, these results are not without exception. In certain
cases, exchange
rates have b e e n f o u n d to deviate significantly from parity.
W e will now briefly
discuss the different possibilities as to h o w these deviations
could o c c u r in the
context of o u r research.
P P P theory assumes that there are no barriers to trade. It has
long b e e n

15. recognised that such barriers prevent arbitrage from taking
place and lead to
d e p a r t u r e s from parity. 16 In the case of a Big Mac, for
instance, the cost o f
i m p o r t e d b e e f in J a p a n (which accounts for nearly
80% o f the ingredients in a
Big Mac) includes a 50% tariff. 17 Big Mac prices could also b
e distorted by
high taxes in countries such as D e n m a r k and Sweden and
inflated p r o p e r t y
costs in H o n g Kong, J a p a n and Singapore, which could
exaggerate the degree
o f d e p a r t u r e f r o m parity for these currencies. It has
also o f t e n b e e n held that
the failure o f the law o f one price is due, in large part, to
systematic attempts
by firms operating in international markets to stabilise
destination m a r k e t
prices, when nominal exchange rates change, in o r d e r to p r
o t e c t m a r k e t
share. ~s A n o t h e r reason for observed d e p a r t u r e s
from Big M a c P P P is the
'status symbol' argument, which suggests that in certain
countries, fast-food
chains in general (and the M c D o n a l d ' s franchise in
particular) are rarities and
are thus able to c o m m a n d a m o n o p o l y p r e m i u m
over o t h e r commodities. This
is n o t the case in the U S w h e r e intense competition from
o t h e r fast-food
chains w o u l d serve to k e e p margins slim. A further i m p
o r t a n t reason for
deviations from P P P is the existence o f productivity
differences b e t w e e n
countries, m e n t i o n e d earlier. This will b e investigated in
the next two sections.

16. III. Is the Big M a c all tradeable?
H a r r o d (1939) argues that P P P holds true for t r a d e d
goods ( T ) only, as the
prices o f these goods are purcly thc effect of exchange rate
movements.
Accordingly, these prices should not vary outside the limits sct
by transporta-
tion costs and tariffs. T h e r e f o r e P P P should no longer
hold o n c c n o n - t r a d e d
goods ( N ) are taken into account, sincc they are not expected
to have the same
prices in different countries except u n d e r spccial
circumstances. Balassa (1964)
subsequently formalises H a r r o d ' s exposition by looking at
deviations f r o m P P P
870
Bu~ernomics: the economics of the Big Mac standard: Li Lian
Ong
in the context o f productivity biases. H e finds that m a r k e d
productivity differ-
entials in T b e t w e e n 'rich' and ' p o o r ' countries, along
with wage equalisation
within each economy, cause the prices o f T in terms of N to b
e c h e a p e r in the
richer economies. W e will use this a p p r o a c h as a basis
for slicing the Big M a c
into its T and N components.
Clements and Frenkel (1980) take the price level to b e a linear

17. h o m o g e n e o u s
( C o b b - D o u g l a s ) function of the prices of n o n - t r a d
e d goods, P!v, and t r a d e d
goods, PT, with weight ~ given to N:
( 3 ) e - ". 1 - . - P , ~ PT ,
w h e r e 0 < ce < 1 Thus, if P P P applies to T only, then S =
P r / P ~ and it follows
that
(45 P r = S . P ~ .
By rewriting Eq. ( 3 ) for the foreign country and rearranging b
o t h versions o f
the equation, we are then able to substitute P r and P.~ in Eq.
(4) to obtain
( 5 ) S = ( P r / P N ) " . P---
( p . ~ / p ~ ) " " p * •
Looking at Eq. ( 5 ) , we can see that the ( P T / P N ) a t e r m
b e c o m e s smaller, on
the basis o f a simple P P P calculation, as T b e c o m e s
relatively c h e a p e r to N in
the rich country, as explained by the P B H . In o t h e r words,
since N e n t e r into
the calculation o f PPP, via the overall price level, b u t do not
directly affect
exchange rates, the currency of the richer country will a p p e a
r to b e 'overval-
ued'.
C o n s i d e r also the Clements and S e m u d r a m (1983)
relationship b e t w e e n
relative prices and G D P p e r capita: 1~

18. ( 6 ) log ~ = A + 0 5 1 o g G D P .
W e rewrite Eq. ( 6 ) for the foreign e c o n o m y and
substitute b o t h versions o f the
equation into the logarithmic form o f Eq. ( 5 ) to obtain
( 7 ) log S = 3 , + / 3 log G D P - / 3 * log G D P * + log ~ ,
w h e r e 3/= c~A - c~*A*, /3 = c~05 and /3* = a'05".
Assuming for expository pur-
p o s e s that ~ = ~* and 05= 05*, /3 would then b e equal to
/3*. W e also
i n c o r p o r a t e the definition in Eq. ( 1 ) so that Eq. ( 7 ) b
e c o m e s
, ( G D P ~
( 8 ) r = y ' + / 3 l o g i c ) ,
w h e r e 7 ' = - ~ and /3' = - / 3 . 2o As the coefficient /3 =
o~05, with 0 < a < 1 and
05 < 0, we expect 13 < 0 and /3' > 0. The estimates of Eq. ( 8 )
are given in Table
2 . 21
The estimate o f /3' in Table 2 indicates that, on average, a 10%
growth in
G D P causes a 2 % appreciation o f the currency in real
terms. Recall that o n e
of the structural p a r a m e t e r s o f this m o d e l is o~, the
share o f non-tradeables in
871

19. Burgemomics: the economics o f the Big Mac standard." Li
Lian Ong
TABLE 2. Regression results: currency valuation and G D P c r
o s s - c o u n t r y / t i m e - s e r i e s ,
1986-1994 (standard errors in parentheses)
, [ G D P
I n t e r c e p t coefficient y '
Coefficient of relative G D P / 3 '
A d j u s t e d R 2
S t a n d a r d error of estimate
0.259 (0.026)
0.240 (0.023)
0.415
0.266
total costs. As the coefficient /3' = - a4,, we can obtain an
estimate o f a given
estimates o f /3' and ~b. We use the Clements a n d S e m u d r
a m (1983) estimate
(h = - 0.256 to derive ~ = 0.937. Thus, the n o n - t r a d e d c o
m p o n e n t in a Big Mac
accounts for approximately 94% o f its price. This figure
appears reasonable
given the p r o m i n e n c e o f wages, rent, o t h e r
overheads, etc. in the cost o f a Big
Mac.
IV. Improving the Big Mac Index: the No-Frills Index
As previously discussed, PPP t h e o r y needs to bc extended
to take account o f
n o n - t r a d e d goods. O u r calculations in t h e previous

20. section indicate that, on
average, non-tradcablcs account for approximately 94% o f the
h a m b u r g e r
prices. Since these goods play only a very small part in
determining exchange
rates, they should be excluded in a m o r e sophisticated PPP
calculation. We
pursue this idea in this section by introducing the No-Frills
Index (NFI) in
which the non-tradeables arc excluded from t h e Big M a c
Index (BMI).
We rewrite Eq. (4) in logarithmic form to r e p r e s e n t t h e
PPP condition:
(9) log S = log PT -- log P~
= f ( l o g P , log GDP) - f * (log P * , log GDP*)
g ( l o g ~ - . , ' G D P , =
In the above, the second line reflects Eqs. (3) a n d ( 6 ) and
their foreign-coun-
try counterparts. The third line invokes (i) a h o m o g e n e i t y
assumption that
prices at h o m e relative to those abroad affect the exchange
rate; and (ii) an
assumption that the relevant p a r a m e t e r values are
identical in the two coun-
tries (o~ = a * and ~h = ~b*, in the notation o f Section III).
Once we have an estimate o f the p a r a m e t e r s o f t h e
function g (-, .) in Eq.
(9), we can estimate the NFI as log S = ~ (log P/P*, log
GDP/GDP*). It can
be shown that the N F I is c o m p u t e d as log S -- log S - k,

21. w h e r e S is the actual
exchange rate and k is the residual from regression (8). 22 A n o
t h e r way o f
visualising the N F I is that it incorporates the systematic
relationship b e t w e e n
departures from parity according to t h e B M I and GDP; this
relationship is t h e
productivity bias Eq. (8). F o r illustration purposes, Table 3
presents t h e N F I
872
Burgernomics: the economics o f the Big Mac standard: Li Lian
Ong
TABLE 3. A c t u a l e x c h a n g e r a t e s , t h e Big M a c
I n d e x a n d t h e N o - F r i l l s I n d e x
C o u n t r y
L o g a r i t h m i c
A c t u a l
e x c h a n g e r a t e
(1)
L o g a r i t h m i c d i f f e r e n c e s x 100
Big M a c N o - F r i l l s A c t u a l E R - A c t u a l E R -
B M I -
I n d e x I n d e x B M I N F I N F I

22. (2) (3) (4) = (1) - (2) (5) = (1) - (3) (6) = (2) - (3)
1994
A r g e n t i n a 0.00 0.45 0.47 - 4 5 . 1 1 - 4 7 . 3 0 - 2 . 2 0
A u s t r a l i a 0.35 0.07 - 0.09 28.30 44.18 15.88
A u s t r i a 2.48 2.69 2.47 - 20.97 1.96 22.94
B r i t a i n - 0.38 - 0.24 - 0.39 - 13.94 0.81 14.75
C a n a d a 0.33 0.22 0.04 11.42 28.47 17.05
C h i l e 6.03 6.02 6.23 0.48 - 20.38 - 20.87
C h i n a 2.16 1.36 2.10 79.98 6.16 - 7 3 . 8 2
D e n m a r k 1.90 2.42 2.16 - 5 1 . 5 3 - 2 5 . 5 2 26.01
F r a n c e 1.76 2.08 1.87 - 32.14 - 10.89 21.25
G e r m a n y 0.54 0.69 0.49 - 15.67 5.03 20.69
G r e e c e 5.53 5.60 5.60 - 7.30 - 7.75 - 0.45
H o l l a n d 0.65 0.86 0.66 - 21.58 - 1.66 19.92
H u n g a r y 4.63 4.30 4.49 33.77 14.93 - 18.85
I t a l y 7.40 7.59 7.43 - 18.68 - 2.82 15.86
J a p a n 4.64 5.14 4.80 - 49.14 - 15.88 33.26
M a l a y s i a 0.99 0.49 0.72 49.48 26.79 - 22.70

23. M e x i c o 1.21 1.26 1.45 - 4 . 6 5 - 2 3 . 7 6 - 19.11
P o l a n d 10.02 9.51 9.82 50.95 19.48 - 31.47
P o r t u g a l 5.16 5.25 5.28 - 9.32 - 12.27 - 2.95
R u s s i a 7.48 7.14 7.47 34.19 1.64 - 32.54
S i n g a p o r e 0.45 0.26 0.04 18.87 41.20 22.33
S o u t h K o r e a 6.70 6.91 6.92 - 21.07 - 22.53 - 1.46
S p a i n 4.93 5.01 4.94 - 8.34 - 1.62 6.72
S w e d e n 2.08 2.41 2.20 - 33.13 - 12.01 21.12
S w i t z e r l a n d 0.36 0.91 0.58 - 54.36 - 21.88 32.48
T h a i l a n d 3.23 3.04 3.36 19.25 - 12.58 - 31.83
M e a n - 3.09 - 1.85 1.23
S t a n d a r d e r r o r o f m e a n 6.76 4.21 5.08
t - s t a t i s t i c - 0.46 - 0.44 0.24
for 1994, as well as the test statistics for that year. N o t e that
for China, one o f
the poorest countries in the sample, the deviation o f the BMI
from the actual
exchange rate is approx. 80%; when the NFI is used, the
deviation falls to
approx. 6%.
We find that, on average, the excess o f the BMI over its No-

24. Frills counter-
part is approx. 10%, over the 1986-1994 period. 23 In other
words, the BMI
undervalues currencies by 10%, on average. Consequently, if
The Economist
magazine wishes to make some rough adjustments to its BMI to
allow for
productivity bias, a simple approach would be to add 10% to its
estimates o f
currency values, especially for the poorer countries.
873
Burgernomics: the economics o f the Big Mac standard: Li Lian
Ong
V. Summary and conclusion
The Economist magazine is considered the most influential and
prestigious
financial n e w s p a p e r in the world. In view o f its well-
known breezy style which
has b e e n described as 'simplify and then exaggerate', one
suspects that w h e n
the editor first i n t r o d u c e d the Big Mac Index in 1986, it
was a s o m e w h a t
tongue-in-cheek contribution to what is perhaps the m o s t
widely-researched
and d e b a t e d doctrine in international finance. M a n y
years later, the Big M a c
Index is still going strong and is now widely cited and u s e d
by academics and
practitioners alike. Given the competitive nature o f publishing,
one would

25. assume that the survival o f the index would have to be b a s e
d on s o m e intrinsic
merit and usefulness o f the m e a s u r e in judging the long-
term value o f curren-
cies.
O u r test results d e m o n s t r a t e that the Big M a c Index
is surprisingly accurate
in tracking exchange rates o v e r the longer-term, which is
consistent with
previous findings. The regression tests indicate that purchasing
p o w e r parity
holds with the Big M a c Index over a 9-year horizon. H o w e
v e r , this is n o t to say
that the currencies o f all individual countries for all years are
at parity.
G e o g r a p h i c influences a p p e a r to play a part in those
instances w h e r e devia-
tions from parity occur. F o r example, the currencies o f
developing Asian and
East E u r o p e a n countries are consistently undervalued,
while the currencies o f
the industrialised e c o n o m i e s are overvalued, on average.
The versatility o f the Big M a c Index notwithstanding, we are
still able to
improve on it by taking into account the existence o f
productivity bias b e t w e e n
countries. As it is well known, services are relatively c h e a p e
r in p o o r e r
countries and because these goods have little, if any, role in
determining
exchange rates, standard P P P calculations which include
services tend to show
that the currencies o f these countries are systematically
undervalued. In o t h e r

26. words, these deviations from parity are related to income. W e
confirm the
existence o f this productivity bias in the Big Mac Index and
subsequently
introduce the new No-Frills Index to solve the problem. T h e n
e w index
excludes the n o n - t r a d e d c o m p o n e n t o f Big Mac h
a m b u r g e r s in computing
parity. Interestingly, we estimate that this c o m p o n e n t
accounts for as much as
94% o f the cost o f a Big Mac. O u r new results indicate that
the No-Frills Index
p e r f o r m s even b e t t e r than the Big Mac Index,
especially for the p o o r e r
countries and could b e o f use to practitioners and policy-
makers.
Notes
1. The origins of PPP theory are analyzed in detail by Frenkel
(1976) and Officer (1982).
2. Studies by A d l e r and Lehmann (1983), Huizinga (1987)
and Meese and Rogof~ (1988)
are unable to reject the hypothesis that real exchange rates
follow a r a n d o m walk under
the floating exchange rate regime. However, recent studies by A
b u a f and Jorion (1990),
D i e b o l d et al. (1991) and Lothian (1990) find evidence o f
mean-reverting behavior in
real exchange rates using long-term time series data. O t h e r
research into real exchange
rate behavior during the float include Dornbusch (1987), F r a n
k e l and M e e s e (1987),
M e e s e (1990) and Officer (1976). Recent surveys o f the
literature are provided by

27. Lothian (1997), R o g o f f (1996) and Taylor (1995).
874
Burgernomics: the economics of the Big Mac standard: Li Lian
Ong
3. F r o o t and R o g o f f (1994) and Officer (1982) provide
comprehensive reviews o f the
l i t e r a t u r e in this area.
4. As an example, consider a two-country, two-good (traded and
non-traded, T and N )
world, where one country is rich and the o t h e r poor. Let the
rich country be m o r e
productive in the production of both T and N. Although this
country has an absolute
advantage in both goods, it is plausible to postulate that it is
relatively m o r e productive
in T. The reason lies in the nature of N which have large service
c o m p o n e n t s and are
labor-intensive. Thus, productivity improvements are m o r e
difficult in these areas.
Consequently, the relatively higher productivity o f T in the
rich country means that
their relative prices will be c h e a p e r in the rich country (in
terms of N).
5. The mechanics of this concept are discussed in further detail
in Section III. O t h e r
research into the PBH include Bartolini (1995) and Clemcnts
and S e m u d r a m (1983).
6. See Summers and H e s t o n (1991) for a description of the

28. data.
7. T h e r e have been strong criticisms o f the reliability of
the ICP method, however. They
include the fact that (i) world average prices are used to value
the G D P c o m p o n e n t s ,
which means that since world average prices are d o m i n a t e
d by the larger weights o f rich
countries, price weights that are not reflective of the low-
income countries t e n d to push
up their relative quantity indices (Isenman, 1980); (ii) the ICP
prices ' c o m p a r i s o n
resistant' services, which have no identifiable unit of output
which could be easily priced
(Maddison, 1983); and (iii) ICP d a t a are only g a t h e r e d
at 5-year intervals (beginning in
1970) and country coverage is limited, which means that data
from n o n - b e n c h m a r k years
and countries must be o b t a i n e d by extrapolation;
moreover, there is also a long time lag
between collection of the d a t a and their availability (Rogoff,
1996).
8. The Big Mac hamburger is p r o d u c e d locally in more
than 80 countries a r o u n d the world,
with only minor changes in recipe. It is 95 mm in diameter,
weighs 205 g and generally
uses the same ingredients everywhere - - two b e e f patties, a
special sauce, lettuce,
cheese, pickles and a sesame-seed bun ( L o o k Japan, June
1994). As well as being a
' s t a n d a r d product', this means that its local prices are less
likely to be d i s t o r t e d by
international t r a n s p o r t a t i o n and distribution costs.
9. t-test results indicate that the majority of the W e s t e r n

29. and Central E u r o p e a n currencies
a p p e a r to deviate significantly from parity at the 0.1%
level. Only I r e l a n d is at parity
with the US. In the A m e r i c a s group, parity with the US is
achieved by Mexico and
Brazil, while Canada, surprisingly, deviates from its North A m
e r i c a n neighbour at the
5% level. This result could perhaps be explained by Engel and
Rogers' (1995) finding
that crossing the US C a n a d i a n b o r d e r is equivalent to
adding 7182 miles between two
cities in the same country, in the context o f price differences
between locations.
Meanwhile, all the A S E A N - O c e a n i a currencies are
significantly undervalued. Results of
t-tests for parity by region indicate that except for Western and
Central E u r o p e which is
significantly overvalued, all o t h e r regions are, on average,
either undervalued or at
parity with the US. The currencies o f A S E A N - O c e a n i a
and Eastern E u r o p e are
significantly undervalued by approx. 28%, while the null
hypothesis of PPP holds for the
A m e r i c a s and East Asia. These findings are explained to
some extent by F r a n k e l and
W e i ' s (1995) research into the existence o f currency blocs.
Finally, the t-statistic for the
entire sample indicates that the currencies, averaged over time
and countries, deviate
significantly from parity at the 5% level.
10. Results of t-tests seem to imply that the over- or under-
valuation of each currency, with
respect to the US dollar, t e n d to offset one another on an
annual basis. W i t h the
exception o f 1987, when the US dollar is significantly

30. undervalued at the 1% level, it
a p p e a r s that the US dollar is m o r e or less at parity in
each year. Cumby (1996) finds that
deviations from Big Mac PPP are useful for forecasting
exchange rates. A f t e r account-
ing for currency-specific constants, a 10% undervaluation in 1
year, according to the Big
Mac Index, is associated with a 3.5% appreciation over the
following year.
11. Initially, we estimate Eq. ( 2 ) for each year, using cross-
country data; the results are
given in the first part o f Table 1. The adjusted R 2 figures
indicate a very significant
relationship between the implied and actual exchange rates on a
year-by-year basis. The
hypotheses of a zero intercept, a unit slope coefficient and the
joint hypothesis o f a z e r o
875
Burgernornics: the economics of the Big Mac standard." Li Lian
Ong
intercept and unit slope coefficient cannot be rejected for any 1
year, except for 1986
and 1987. Next, we pool the data over time and across
countries; the results are
p r e s e n t e d in the second part o f Table 1. In this case,
both the null hypotheses, when
taken separately, cannot be rejected. However, the joint
hypothesis is rejected at the 5%
level o f significance.

31. 12. F r a n k e l and R o s e (1995), H a k k i o (1984) and Oh
(1996) show that the higher variability
in cross-sectional data, relative to time-series data, allows for m
o r e precise p a r a m e t e r
estimates in tests of PPP. Similarly, Cumby (1996) d e m o n s t
r a t e s that a larger cross-sec-
tion yields enough power to detect substantial mean-reversion
in his tests of Big Mac
PPP. H e finds little persistence in deviations from Big Mac
PPP, with only 30% o f
deviations persisting into the following year
13. As can be seen in the third part of Table 1, the adjusted R 2
remains very high at 98%.
The intercept and slope coefficient are not significantly
different from zero and unity,
respectively, while the joint hypothesis for the slope and
intercept also cannot be
rejected. This finding of long-run PPP is consistent with the
results o f A b u a f and Jorion
(1990), D i e b o l d et al. (1991), Frenkel (1981), Lothian
(1990) and Officer (1976). M a n z u r
(1990) shows that the long-run in PPP terms is 5 years.
14. See Blundell-Wignall et al. (1993), Edison and Pauls (1993)
and F r o o t and Rogoff
(1994). Note that as our d a t a observations are both across
countries and over time,
non-stationarity may not be such a problem as c o m p a r e d
with the situation with pure
time-series data.
15. The results o f the relative parity regressions o f annual
data are given in the first part o f
Table 1. With the exception of 1986/1987 and 1987/1988, we
find the adjusted R - to be

32. very high for each year. However, the joint hypothesis o f a
zero intercept and unit slope
is rejected for all years except 1990/1991. The j o i n t
hypothesis is also rejected when
averaged d a t a are used. W h e n the d a t a are pooled across
countries and over time, the
adjusted R 2 is approx. 90%. In this instance, both the null
hypotheses of a zero
i n t e r c e p t / u n i t slope coefficient as well as the joint
hypothesis cannot be rejected.
16. See H a r r o d (1939).
17. Look Japan, June 1994.
18. Firms are said to ' p r i c e to m a r k e t ' when they charge
different local prices across export
markets to reflect the particular local competitive situation; any
exchange rate move-
ment is a b s o r b e d by altering the home currency export
price (Ghosh and Wolf, 1994).
Cumby (1996) finds that relative local currency prices a p p e a
r to adjust to reduce
deviations from Big Mac PPP.
19. Using the price of haircuts in 24 countries to measure the
price of N, they find a strong
positive association between the price of a haircut and the GDP.
They estimate the
income elasticity o f the relative price of T, as r e p r e s e n t e
d by the regression coefficient
~/, in Eq. ( 6 ) , as being equal to - 0 . 2 5 6 , with s t a n d a r
d e r r o r 0.061. Their finding that N
become relatively more expensive with increasing income is
consistent with the PBH.
20. Note that the negative o f r, as defined in Eq. (1), is the

33. conventional definition of the
real exchange rate.
21. To estimate Eq. ( 8 ) , we use the d a t a on r, calculated in
Section I, and G D P figures
o b t a i n e d from the International Financial Statistics of the
International M o n e t a r y F u n d
(1996). Observations are omitted in instances where G D P d a
t a are unavailable.
22. See Ong (1995).
23. Not shown in Table 3; see Ong (1995) for calculation
details.
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Taylor, M. P. (1995) The economics of exchange rates. Journal
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878
The Big Mac Index •
Topic: The Big Mac Index Write an essay more than 1000
words, excluding reference,
explaining the Big Mac Index and its advantages and limitations
in measuring PPP. Describe
the possible cause(s) of the failure of PPP that you learned in
the lecture. Also, examine the

40. conclusion from The Economist (article link below) that “[t]he
Chinese yuan, for example, is
44% undervalued against the dollar”. The following articles can
help you with the essay:
– http://www.economist.com/news/finance-and-
economics/21714392-emerging-market-
currenciesand-euro-look-undervalued-against-dollar-our-big
– Ong, L.L., 1997. Burgernomics: the economics of the Big Mac
standard. Journal of
International Money and Finance, 16(6), pp.865-878.
You are encouraged to search for more references or materials.
The reference should be in
Harvard style.