Can a Big Mac tell you what a currency is worth?
The interest-rate conditions in the last two lessons say nothing about whether a currency is cheap. For that you need a different anchor — one built on prices rather than rates. It is the oldest idea in international economics, it is genuinely useful over decades, and it is close to worthless over months.
The idea in two versions
The law of one price. An identical good should cost the same everywhere once converted into a common currency, because otherwise you could buy it where it is cheap and sell it where it is dear.
Absolute purchasing power parity extends that to a whole basket: the exchange rate should equal the ratio of the two countries' price levels.
Relative PPP is the version worth memorising, because it is the one with any empirical support:
% change in the exchange rate ≈ inflation differential
A country running 6% inflation against one running 2% should, over time, see its currency depreciate at roughly 4% a year. That is the same insight as the real-rate arithmetic in Unit 1: what looks like a spectacular interest rate is often an inflation rate wearing a disguise.
The Big Mac index as a teaching device
The Economist launched its Big Mac index in September 1986, half in jest, and it has outlived most serious models. The logic is one line of arithmetic, using rounded illustrative figures:
A Big Mac costs $5.70 in the United States and ¥480 in Japan. The implied exchange rate is
480 / 5.70 = 84.2 yen per dollar
If the actual rate is 150, then
84.2 / 150 − 1 = −43.9%
and the yen is, on this measure, about 44% "undervalued" against the dollar.
The burger is a good teaching device for a specific reason: it is a bundle. Beef and packaging are tradeable; rent, wages, electricity and local competition are not. That mix is exactly where PPP goes wrong.
Why it fails in the short run
- Non-traded inputs. You cannot arbitrage Tokyo rent against Ohio rent.
- Balassa–Samuelson. Richer countries have higher productivity in tradable sectors, which lifts wages economy-wide, which lifts the price of non-tradables. Their price levels are systematically higher — so a poor country's currency will look permanently "undervalued" without any mispricing at all.
- Trade costs, tariffs and taxes. VAT alone differs by 20 points across countries.
- Margins and market structure. Firms price to market rather than to arbitrage.
- Sticky prices. Exchange rates move in seconds; menus move in years.
What the evidence actually shows
The consensus estimate, summarised by Rogoff in 1996, is that deviations from PPP decay with a half-life of roughly three to five years. Read that carefully: half of a mispricing is still there after three to five years, and the other half takes as long again. At horizons under a year PPP has essentially no explanatory power. Meese and Rogoff had already shown in 1983 that no structural exchange-rate model reliably beat a random walk out of sample at horizons up to twelve months — a result that has been re-tested many times and has mostly held.
The right way to hold the idea
PPP is an anchor on a very long chain. It tells you where the ship eventually drifts back toward; it tells you nothing about where the ship is next Tuesday, and a currency can sit 40% away from PPP for a decade while paying you nothing for noticing. "Undervalued on PPP" is a description of a price level, never a timing statement and never a recommendation.
In the data
The price levels the theory compares are published like the US series below: one number a year, as an index set to 100 in 2010.
Both features bite. Once a year means a PPP ratio updates annually against an exchange rate that reprints every minute, and an index carries relative change only: it says US prices rose about 44% from 2010 to 2024, not what the basket costs in dollars, which is the quantity absolute PPP is written about.
Try it now
- Below are the United States' and Japan's annual inflation rates, one per year, newest first. The two series do not end in the same year, so take the ten years both tables share. Compound each side, multiplying the (1 + inflation) terms, and compute the cumulative inflation differential.
- The corresponding pair, USD/JPY in yen per dollar, is below at full length. Measure it from the last bar of the year before your decade starts to the last bar of its final year, and write the actual cumulative move down.
- Compare the two numbers: relative PPP says the higher-inflation currency should have lost roughly the differential. Then repeat the comparison over the most recent single year the two tables share, and write one sentence on how the two horizons differ.