Big Mac Index shows NZ dollar is undervalued

The New Zealand dollar is weaker than it should be, if the price of Big Macs are anything to go by.

The Economist this week released the latest Big Mac Index, which looks at how much the popular burger costs around the world, and compares it to the strength of each country's currency.

The magazine, which invented the Big Mac Index in 1986, calls it a "lighthearted guide to whether currencies are at their 'correct' level". 

"It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries."

The Big Mac was chosen because its maker, McDonald's, has global reach, and it's a largely standardised product that doesn't change too much wherever you buy it. 

According to 2020's index, the New Zealand dollar is 24 percent undervalued compared to the US dollar, which is the world's reserve currency (meaning most countries have stores of it in their reserves and  it can be used in international transactions). 

While a Big Mac here costs NZ$6.60, in the US they're US$5.71 - implying an exchange rate of 1.16, well below the actual exchange rate of 1.52. This means if pulled up to a drive-thru in New York with NZ$6.60, you wouldn't have enough to buy a Big Mac, because that only converts to US$4.35. You'd be a bit short.

The 2020 Big Mac Index.
The 2020 Big Mac Index. Photo credit: The Economist

Exporters tend to like it when a currency is undervalued, because foreign currencies convert to more of the local currency than usual. When a dollar is overvalued, importers like it because they can buy more from overseas at a lower price.

The normal Big Mac Index doesn't take into account the fact identical products are often cheaper in poorer countries, as labour costs are usually lower. To combat this, The Economist has also developed a GDP-adjusted index.

"The relationship between prices and GDP per person may be a better guide to the current fair value of a currency."

Even on this metric, the NZ dollar is undervalued compared to the greenback. Remember, a Big Mac there costs 24 percent more than here. 

"Based on differences in GDP per person, a Big Mac should cost 17 percent less. This suggests the dollar is 8.2 percent undervalued."