The Economist has released its 2007 Big Mac Index this month. The metric, based solely on the famed Big Mac, has become one of the best known foreign exchange rate forecasters in the world. See what the two all-beef patties predict for this year...

The index to the right (click on the image to see a full-sized version) is based on the purchase price parity theory of exchange rates, which says that currency values should adjust so that identical goods end up being priced the same in the long run. The chart shows what the Big Mac should cost in the local currency if it were to be priced at the exact same cost in US dollars. If the actual price is over the predicted price, the theory predicts that the currency will devalue in the long term. If the actual price is below the predicted price, the currency should appreciate.

Based on this chart it looks like Iceland is way out of whack on the upside and should be plummeting in the future. We can also see why everyone is peeved about China's resistance to appreciating its currency - it's undervalued by about 56% based on this measure.

Interestingly, a new index might be trumping the Big Mac Index in the near future. The iPod's market reach is growing exponentially, and it too is an identical product that could lend itself to similar price comparisons. The iPod also has the advantage of being consistently produced in China, whereas Big Macs include costs of local country labor (with different educational backgrounds, demographics, etc.) that can further distort the price of the good.

Only time will tell whether an iPod index will have the same success as the Big Mac index in forecasting exchange rates. Even if it does, I highly doubt that it will become as popular. The product is too sterile and still remains at a price-point better suited for middle class yuppies than for the average citizen, which means it lacks the familiarity appeal of the Big Mac index.

Besides, can a consumer product really be the key to global forecasting without a special sauce??

Posted by Michelle Smith on February 10, 2007 04:31 PM