Purchasing Power Parity and the Big Mac Index: What Currencies "Should" Be Worth

Market exchange rates routinely disagree with PPP for years at a stretch, and both the idea and the disagreement are informative. This article explains the concept, its famous fast-food thermometer, why real exchange rates wander from "fair value" — and what PPP is genuinely for, which is not currency trading.

The idea, and its burger-shaped teaching tool

PPP extends the law of one price — identical goods should cost the same everywhere once converted — from single goods to whole baskets. In its practical, relative form: countries with persistently higher inflation should see their currencies depreciate over time by roughly the inflation differential, keeping real purchasing power aligned — a long-run tendency with substantial empirical support over decades, and famously weak guidance over months. The Big Mac index, published by The Economist since 1986, is the concept's beloved classroom version: the same standardised burger, priced in dozens of countries, converted at market rates — where it costs less than in the US, the local currency trades "undervalued" against burger-PPP; where more, "overvalued." Its publisher presents it as pedagogy rather than precision, and it works as exactly that: a one-item basket making an abstract parity condition edible.

Why market rates wander from PPP

The gaps are systematic, not mysterious. Non-tradables: a haircut in Bratislava cannot be arbitraged against a haircut in Zurich — services, rent, and local labour never face the equalising pressure that shipped goods do, and they are a large share of any real basket. The related regularity (the Balassa–Samuelson effect, in the literature's vocabulary): richer, higher-productivity countries have systematically higher price levels, so poorer countries' currencies persistently look "undervalued" on PPP without anything being mispriced. Trade frictions: transport, tariffs, taxes, and distribution wedge prices apart even for tradable goods. Capital flows: in the short and medium run, exchange rates are asset prices moved by interest differentials, risk appetite, and portfolio flows — forces with no obligation to respect grocery prices, developed further in this pillar's currency article. The honest summary: PPP describes a slow gravitational pull; capital flows fly the plane day to day.

What PPP is actually for

Three legitimate uses, one illegitimate. Comparing economies: converting GDPs at market rates understates poorer countries' real activity (their non-tradables are cheap); GDP at PPP corrects for price levels, which is why country rankings differ visibly between the two measures and why international statistics publish both. Comparing incomes and costs: salaries, pensions, and cost-of-living comparisons across countries mean little at market rates and much at PPP — the practical version of the concept most readers will actually use. Long-run anchoring: persistent, extreme PPP deviations are one input analysts weigh when judging whether a currency is historically stretched — context, not signal. The illegitimate use is the tempting one: PPP "undervaluation" as a trade. Deviations persist for years and often widen before narrowing; a valuation anchor with a multi-year, unreliable pull is not a timing tool, and the Big Mac index's own publisher says as much. The pattern matches this pillar throughout: the concept explains the landscape; it does not schedule the weather.