The Big Mac Index
The Economist’s Big Mac Index, created in 1986, is the most famous application of PPP. It compares the price of a McDonald’s Big Mac across countries as a proxy for a standardised basket of goods (labour, rent, ingredients, brand). If a Big Mac costs £4.50 in the UK and $5.80 in the US, the implied PPP exchange rate is £1 = $1.29. If the actual exchange rate is £1 = $1.25, sterling appears slightly undervalued against the dollar on this measure. The Big Mac Index is an imperfect proxy (Big Mac prices reflect local wages, rents, and taxes, not just pure PPP), but it provides an accessible illustration of the concept and has proven surprisingly predictive of long-run exchange rate movements.
Why PPP deviations persist
Several structural reasons explain why exchange rates deviate from PPP. The Balassa-Samuelson effect explains why poorer countries consistently have undervalued exchange rates relative to PPP: their tradeable goods (manufacturing) are competitive, but non-tradeable services (haircuts, restaurant meals, housing) are cheap because wages are low. As countries develop, non-tradeable prices rise, and their currencies appreciate toward PPP. Capital flows dominate short-term exchange rate movements, overwhelming trade-based PPP adjustments. Non-tradeable goods (which make up roughly 60–70% of GDP) are not subject to the arbitrage that would enforce PPP. Trade barriers and transport costs prevent perfect arbitrage even for tradeable goods.
What this means for you
PPP-adjusted figures are the correct ones to use when comparing economic sizes and living standards across countries. The IMF reports China’s GDP at roughly $18 trillion at market exchange rates but over $30 trillion at PPP — reflecting the fact that Chinese goods and services are much cheaper in dollar terms than PPP would suggest when using market exchange rates. For investors and travellers, PPP serves as a rough guide to whether a currency looks cheap or expensive on a fundamental basis — though currency movements can be driven by capital flows and sentiment for years before reverting to PPP equilibrium.