from Geo-Graphics

Move Over Big Mac: The Law of One Price Is Lovin’ Our Little Mac Index

February 25, 2015

Blog Post
Blog posts represent the views of CFR fellows and staff and not those of CFR, which takes no institutional positions.

More on:

China

Economics

Europe and Eurasia

Monetary Policy

Financial Markets

The “law of one price” holds that identical goods should trade for the same price in an efficient market. To what extent does it hold internationally?

The Economist magazine’s famous Big Mac Index uses the price of McDonald’s burgers around the world, expressed in a common currency (U.S. dollars), to estimate the extent to which various currencies are over- or under-valued. The Big Mac is a global product, identical across borders, which makes it an interesting one for this purpose. Yet it travels badly—cross-border flows of burgers won’t align their prices internationally.

So in 2013 we created our own index which better meets the condition that the product can flow quickly and cheaply across borders: the Geo-Graphics iPad mini Index, which we hereby rechristen the “Little Mac Index.” (H/T: Guy de Jonquieres)

Consistent with our product, iPad minis, being far more tradable than The Economist’s product, Big Macs, our index shows that the law of one price holds much better than theirs does.  The average overvaluation of the dollar according to the Big Mac Index was 19% in January - a Whopper.  The average dollar overvaluation according to the Little Mac Index was a mere 5% - small fries.

So what’s happened since we last updated our index in May?  The U.S. dollar index (the DXY) has appreciated nearly 20%.  The rising dollar is lowering U.S. corporate profits and putting downward pressure on U.S. inflation.  Measured in terms of iPad minis, the dollar has over this period gone from being cheap against most major currencies to being expensive – a reflection of the fact that America’s central bank is almost alone in having virtually committed to tightening policy later in the year.

One notable exception to the dollar’s strength in the Little Mac Index is the Swiss franc, which will buy you fewer iPad minis than the buck.  The franc skyrocketed after the Swiss National Bank unpegged it from the euro on January 15.

When we first launched the index in June 2013, the dollar looked undervalued against most currencies.  Now that the dollar is looking pricey, there is more reason to fear currency conflicts spilling over into the trade sphere.  This is highlighted by the growing threat to a Trans-Pacific Partnership (TPP) trade deal from U.S. corporate interests seeking to hold it up until anti-currency-manipulation provisions can be welded in.

 

Follow Benn on Twitter: @BennSteil

Follow Geo-Graphics on Twitter: @CFR_GeoGraphics

Read about Benn’s latest award-winning book, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order, which the Financial Times has called “a triumph of economic and diplomatic history.”

More on:

China

Economics

Europe and Eurasia

Monetary Policy

Financial Markets

Up
Close