July 28, 2014
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Food for thought: The Big Mac index was created in 1986 to make foreign exchange rates more digestible. Photo: Joe Armao
Exporters may be bemoaning the ‘stubbornly high’ Australian dollar, but according to the Big Mac Index, its valuation is spot on.
That’s right, you heard correctly, burgernomics is a serious business, particularly in determining whether currencies are at their “correct” level.
The price of a Big Mac in America was $US4.80 in July. In Australia it was $US4.81 at market exchange rates, meaning that the Aussie was overvalued by 0.4 per cent, according to The Economist’s raw Big Mac Index.
Photo: McDonald’s; Thomson Reuters; IMF
It is the third time in the past 14 years that the Australian dollar has been valued at the so-called correct level. The other times were in 2013 and 2009 before the local unit began its meteoric rise.
The Aussie remained well above 90 US cents in past weeks, fetching about 94 cents in early trade on Monday. The Reserve Bank has been reluctant to talk down the currency for much of this year, despite its strong jawboning of the dollar in December when it fetched an average of 89.78 US cents.
But the rate of inflation is such that it is making it difficult for the RBA to convincingly suggest it will take action to lower the currency. The consumer price index rose by 0.5 per cent for the second quarter of this year to take the annual headline rate to 3 per cent, which is at the top end of the RBA’s target band.
The Economist newspaper invented the Big Mac Index in 1986 in an effort to make exchange rate theory more digestible.
It is based on the theory of purchasing-power parity – a technique used to the measure the relative vale of different currencies. In an ideal world, exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in The Economist’s case, a burger) in any two countries.
Before 2009 the Aussie had been heavily undervalued, according to the Big Mac Index. In early 2001 a Big Mac cost $US1.52 at market exchange rates, undervaluing the Aussie at 40.3 per cent.
It reached its record high in July 2011, when that same burger cost $US4.94, meaning the currency was then overvalued by 21.6 per cent.
Despite being the subject of at least 20 academic studies, the index has attracted criticism. Much of the argument against the measure has been that average burger prices in poor countries are expected to be cheaper than richer ones because labour costs are lower.
The Economist acknowledges that the relationship between prices and GDP per person may be a better guide to the fair value of a currency, which is why it also includes that measure in the Big Mac Index.
“The difference between the price … for each country, given its income per person and its actual price, gives a supersized measure of currency under- and over-valuation,” the newspaper says.