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# Team project Financial Management in International Business

540 kcal

30g Fat

## Big Mac index

The Big Mac index was introduced in The Economist in 1986 byPam Woodall. Why Big Mac? The index gave rise to the word Burgernomics. Burgernomics is based on the theory of PPP Purchasing Power Parity.

Purchasing power parity (PPP) is an economic theory used to determine the relative value of currencies. The concept is based on the law of one price, where in the absence of transaction costs and official trade barriers, identical goods will have the same price in different markets when the prices are expressed in the same currency.

GDP per capita adjusted for purchasing power parity (PPP) in the world, 2007

## PPP applied to Big Mac Index

The rate between two currencies should naturally adjust so that a samplebasket of goodsand services should cost the same in both currencies. In the Big Mac index, the basket consists of one McDonald's Big Mac, and we've compared it with the average price in America, \$4.20.

12 10 8 6 4 2 0

## How its calculated?

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 higher the first currency is over-valued compared with the second.

Big Mac in Actual dollar Implied PPP local price exchange of US Dollar (I) rate (II) (III)

## 4.20 \$ 70.22 czk 3.50

20.4 1.2987

16.72 0.8333

-18 -13.29

PPP (Italy)= 3.5 / 4. 2 = 0.8333 PPP (Czech Repiblic)= 70.22 / 4.2 = 16.72 -13.29 Under/Over = (III II) / I * 100 Valuation -18

Limitations

## Local taxes Transport Costs Labour laws

The bic mac index may not be representative of the country's economy as a whole.

By fixing the price of the Big Mac to something around 20 pesos, the Argentinian government managed to make the Argentinian peso look not that much over-evaluated w.r.t. the dollar (just 14% last July)

v

## By definition, the real exchange rate measures deviations from PPP.

That is, changes in the spot exchange rate that do not reflect differences in inflation rates between the two currencies in question.
S t +1 E = PPP S t +1

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v

## Appreciation/depreciation in the real exchange rate measures deviations from PPP.

When E = 1, the denominator currency is valued correctly. The competitiveness of this country is unaltered. When E < 1, the denominator currency is undervalued. Products from the other country seem expensive relative to the base year. That is, the competitiveness of the denominator country improves. When E > 1, the denominator currency is overvalued. Products from the other country seem cheap relative to the base year. That is, the competitiveness of the denominator country deteriorates.
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