The Big Mac Index is a numerical tool for assessing disparities in
consumer purchasing power between countries. Suppose that the Big Mac costs 7.50 Canadian dollars in Canada and 5.50 US dollars in the US. Suppose that the nominal exchange rate is 1.2 Canadian dollars to 1 US dollar.
(i) Calculate the real exchange rate.
(ii) Is the Canadian dollar undervalued or overvalued against the US dollar? Explain
To calculate the real exchange rate, follow these steps:
Step 1: Find the relative price of a Big Mac in each country.
In Canada: 7.50 Canadian dollars
In the US: 5.50 US dollars
Step 2: Convert the prices to a common currency (in this case, US dollars) using the nominal exchange rate.
For Canada: 7.50 Canadian dollars / (1.2 Canadian dollars / 1 US dollar) = 6.25 US dollars
For the US: 5.50 US dollars
Step 3: Calculate the real exchange rate by dividing the price in one country by the price in another country.
Real exchange rate = (Price in Canada / Price in the US) x (Nominal exchange rate)
Real exchange rate = (6.25 US dollars / 5.50 US dollars) x (1.2 Canadian dollars / 1 US dollar) = 1.37
(i) Therefore, the real exchange rate between Canada and the US is 1.37. This means that the relative purchasing power of consumers in Canada compared to the US is 1.37 times higher. In other words, consumers in Canada can buy 1.37 times more goods and services than those in the US with the same amount of money.
(ii) To determine if the Canadian dollar is undervalued or overvalued against the US dollar, we compare the real exchange rate (1.37) to the nominal exchange rate (1.2 Canadian dollars to 1 US dollar). If the real exchange rate is higher than the nominal exchange rate, it means that the Canadian dollar is overvalued. Conversely, if the real exchange rate is lower than the nominal exchange rate, it means that the Canadian dollar is undervalued.
In this case, the real exchange rate (1.37) is higher than the nominal exchange rate (1.2). Therefore, the Canadian dollar is considered to be overvalued against the US dollar.