A woman looks at a creation by Tom Friedman named 'Big Big Mac' during the unveiling of the Arts & Food exhibition at the Triennale, as part of the next Expo 2015, in downtown Milan.
(photo credit: REUTERS)
If international exchange rates can be extrapolated from the cost of a beef patty with lettuce, tomato, pickles, cheese and a sesame-seed bun, then the shekel is too strong.
In the July update of its famous semiannual Big Mac Index, adjusted based on GDP per person, The Economist found that the Israeli currency was overvalued by 12.2 percent.
The theory behind the Big Mac Index is simple: The same bundle of goods (in this case, everything that goes into a Big Mac) sold in different places around the world should cost the same. In econo-babble, that idea is called purchasing power parity, or PPP.
In the latest accounting, the average Big Mac in the United States cost $4.79. In Israel, the average Big Mac cost NIS 17.50. In a world that conformed perfectly to economic theory, the shekel-to-dollar exchange rate would make those two prices line up, implying that the exchange rate should be NIS 3.65 per dollar.
But the actual exchange rate was NIS 3.78 per dollar. In its simplest form, the Big Mac Index would conclude that the shekel was undervalued by 3.3% as a result of that disparity.
Yet The Economist also has an adjusted version of the Big Mac Index, which takes into account the relative sizes of the economies in question.
Richer countries should have higher labor costs, so the index should be adjusted in accordance with how well off each country is. Once Israel’s GDP per capita was taken into account to adjust for lower labor costs, it showed that the shekel was actually overvalued by 12.2%.
The index, however, should be taken with a grain of salt and a side of ketchup – and seen as a simple demonstration of economic theory. Foreign-exchange traders should note that the Bank of Israel is unlikely to take the Big Mac Index into account when it makes its July 27 decision on the interest rate, which plays an important role in the exchange rate.