The Economist reports on using the McDonald’s Big Mac as an economic indicator. By comparing the prices of burgers in different countries, you can come up with an exchange rate and compare that to conventional market exchange rates and determine if a country’s currency is over- or under-valued, Mac-wise:
The Big Mac index was never intended as a precise forecasting tool. Burgers are not traded across borders as the PPP theory demands; prices are distorted by differences in the cost of non-tradable goods and services, such as rents.
Yet these very failings make the Big Mac index useful, since looked at another way it can help to measure countries’ differing costs of living. That a Big Mac is cheap in China does not in fact prove that the yuan is being held massively below its fair value, as many American politicians claim. It is quite natural for average prices to be lower in poorer countries and therefore for their currencies to appear cheap.
The prices of traded goods will tend to be similar to those in developed economies. But the prices of non-tradable products, such as housing and labour-intensive services, are generally much lower. A hair-cut is, for instance, much cheaper in Beijing than in New York.
One big implication of lower prices is that converting a poor country’s GDP into dollars at market exchange rates will significantly understate the true size of its economy and its living standards. If China’s GDP is converted into dollars using the Big Mac PPP, it is almost two-and-a-half-times bigger than if converted at the market exchange rate. Meatier and more sophisticated estimates of PPP, such as those used by the IMF, suggest that the required adjustment is even bigger.
The two ways of determining the value of currency (and, eventually, the size of a country’s economy) have different results. Using the PPP figures, economies like China and India are much larger than with market exchange rates; China is the 2nd largest world economy by PPP reckoning. As I understand it, a simple way of thinking about this is imagining a Chinese man and an American man meeting and turning out their pockets. The American man would have so much more money than his Chinese counterpart. However, the American lives in the United States and has to purchase products and services at US prices while the Chinese man lives in China and pays Chinese prices. The American may have more to spend, but the Chinese guy can stretch his yuan further.