Question

The Big Mac is considered a good candidate for the application of the law of one price and measurement of under or overvaluation of a currency. Develop an argument as to why this is a good idea.

Answer 1

The relative under or overvaluation of a currency is measured by calculating the price of a basket of goods in different countries. This is called purchasing power parity.

If a basket of goods cost the same in two countries, after taking into account the exchange rates, then the exchange rate between the two currencies is said to be in equilibrium. If the basket of goods cost different, then the exchange rate is not in equilibrium.

This is based on the law of one price, i.e. a basket of goods should cost the same everywhere.

The basket of goods chosen is generally a mix of staple, essential and commonly used goods.

A Big Mac is a good proxy for a basket of goods because it contains staple and essential items such as bread, eggs, meat, cheese, tomatoes etc. It is also commonly available in many countries around the world.

Therefore, a Big Mac is considered a good candidate for the application of the law of one price and measurement of under or overvaluation of a currency