Demystifying some of the jargon used in the global money markets...

The Big Mac index was invented by the economics editor of The Economist in September 1986. It was intended as a humorous illustration of the purchasing power parity (PPP) of the world's major currencies.

Twenty years later the study of burgernomics is still very much part of the cerebral diet of economic pundits across the globe and the Big Mac index is frequently cited by politicians when it happens to suit their particular cause.

The theory goes that exchange rate movements can be predicted by comparing the actual cost of an identical basket of goods in two different countries. In theory, the value of the currencies should adjust over time as a result of market forces so that the basket of goods costs the same in both locations.

The Big Mac index reduces the basket of goods in question to the ubiquitous McDonald's hamburger. Local McDonald's franchises have a significant degree of autonomy in negotiating input costs with suppliers in their territories and the Big Mac, which is currently produced in around 120 countries, has proved to be a resilient and accurate measure of national economies.

If the Big Mac costs more in one country than another at a particular rate of exchange, the currency in the more expensive country can be viewed as being overvalued against the other currency.

For example, according to the latest index, the Big Mac costs $3.10 in the US but, at the prevailing exchange rate on 22 May 2006, the equivalent of $3.65 in the UK. Burgernomicists would therefore argue that sterling is 18% overvalued against the US dollar.

However, in keeping with its comestible namesake, the Big Mac index comes with its own health warning. According to The Economist "The index was never intended to be a precise predictor of currency movements, simply a take-away guide to whether currencies are at their 'correct' long-run level. Curiously, however, burgernomics has an impressive record in predicting exchange rates: currencies that show up as overvalued often tend to weaken in later years. But you must always remember the Big Mac's limitations. Burgers cannot sensibly be traded across borders and prices are distorted by differences in taxes and the cost of non-tradable inputs, such as rents.

The Big Mac index is most useful for assessing the exchange rates of countries with similar incomes per head. Thus, among emerging markets, the yuan does indeed look undervalued, while the currencies of Brazil, Turkey, Hungary and the Czech Republic look overvalued. Economists would be unwise to exclude Big Macs from their diet, but Super Size servings would equally be a mistake."

Photo: AYArktos