Big Macs in big countries: an update on euro area adjustment

What can the Big Mac Index tell us about real exchange rate misalignments in the euro area? Have relative prices between countries adjusted so as to correct them?

Despite its many limitations, The Economist’s Big Mac Index remains a popular and intuitive measure of exchange rate over/undervaluation. In the absence of nominal exchange rates, one would expect prices of Big Macs to vary across euro area countries according to local productivity.

For one thing, Big Mac prices reflect both the competitiveness misalignments that prevailed in the euro area on the eve of the crisis and the subsequent adjustment in the periphery. Despite systematic productivity differentials between Germany and Greece or Italy, in 2011 Big Macs sold for nearly identical prices. As Figure 1 shows, a burger was slightly cheaper in Greece (€3.26) and marginally more expensive in Italy (€3.50) than in Germany (€3.40).

In the years that followed, price increases in the euro-area periphery were contained relative to other euro-area countries, leading to the recovery of competitiveness. Figure 2 illustrates the adjustment in relative prices: by 2018 prices in Greece (+€0.09), Ireland (+€0.27) and Portugal (+€0.35) had increased by less than the euro area weighted equivalent (+€0.63).

Another point to note is that relative prices of Big Macs have not changed among the large euro-area economies. Prices in France and Italy have grown (+0.70 EUR) virtually as much as prices in Germany (+0.72 EUR) (Figure 1) and faster relative to the euro area in general (Figure 2).

To the extent that 2011 prices captured a misalignment in real exchange rates, that misalignment persists (or has possibly been exacerbated by widening productivity differentials in the same period). The International Monetary Fund made this case much more formally in its latest External Sector Report: it found an overvalued real effective exchange rate in France and Italy (by 4% and 5% respectively) and a significantly undervalued one in Germany (by 15%) for 2017.

On a brighter note, however, recent developments may be finally working in the desired direction. Figure 3 helps unpack the story: the relative price gap of Big Macs between Germany on the one hand and France and Italy on the other actually widened from 2011 to 2016, as prices in the former remained flat and continued to rise in the latter. Since 2016, however, these trends have actually reversed, helping to gradually reduce the price differential.

References

International Monetary Fund (2018). 2018 External Sector Report. IMF Policy Paper. July 2018.