Question

The Economist calculates the Big Mac Index as a manifestation of the Law of One Price (LOOP). The purpose of the index is to estimate the over-/undervaluation of a currency. Specifically, it calculates the price of a McDonald’s Big Mac across the four largest metro areas in a given country. These prices, along with the theory of LOOP, imply a theoretical value of the currency—what the value of the currency should be. We can then compare this LOOP-implied currency value to the actual value to determine the over-/undervaluation of a currency.

a)What is the LOOP-implied FX rate?
b)Is the yuan over- or undervalued?
c)By how much is the yuan over/undervalued?
d)Do you think the Big Mac is a proper good to use for LOOP?
e)Can you think of a better good to use? Explain.

Answer 1

The LOOP-implied FX rate is calculated by dividing the price of a Big Mac in one country by the price in another country.

Step-by-step explanation:

The Law of One Price (LOOP) states that in an efficient market, identical goods should have the same price in different locations after adjusting for exchange rates. The LOOP-implied FX rate is the exchange rate that would make the price of a Big Mac equal across different countries. It is calculated by dividing the price of a Big Mac in one country by the price in another country.

To determine if the yuan is over- or undervalued, we compare the actual exchange rate of the yuan to the LOOP-implied FX rate. If the actual exchange rate is lower than the LOOP-implied rate, the yuan is undervalued. If the actual exchange rate is higher, the yuan is overvalued.

To calculate the over/undervaluation of the yuan, subtract the LOOP-implied FX rate from the actual exchange rate. If the result is positive, the yuan is overvalued. If the result is negative, the yuan is undervalued.

The Big Mac is a popular and widely available product that can be compared across different countries. However, it may not be the perfect good to use for analyzing the Law of One Price. Another good that could be used is a commodity such as oil, which is traded globally and has consistent quality and demand.