In 1986, The Economist came up with the Big Mac index as a digestible illustration of exchange rate determination: International Economics Assignment, NIM, Singapore

Question 1

In 1986, The Economist came up with the Big Mac index as a digestible illustration of exchange rate determination. This index has persisted over the years as a thought experiment till today.

Using data from July 2022, the index reported the following:

Big Mac costs 17.7% less in Singapore (US$4.24) than in the United States (US$5.15) at market exchange rates. Based on differences in GDP per person, a Big Mac should cost 6.2% more. This suggests the (Singaporean) dollar is 22.4% undervalued.”

Question 1 A

Examine how the Big Mac index works, and its underlying exchange rate determination theory. What do you think are some limitations of this index?

Question 1 B

For now, suppose that the Big Mac index is an accurate representation of exchange rate determination, and the statement provided in the question is accurate, i.e. “The Singaporean dollar is undervalued relative to the U.S. dollar”.

Consider the following hypothetical scenario: A new locally produced burger has become very popular in Singapore. Consumption of the Big Mac has gone down in Singapore, as Singaporeans switch to this locally-produced burger.

Using a diagram (with USD/day on the x-axis). analyze the changes in the foreign exchange market and its effects on the exchange rate. For this question, there is no need to explain the limitations of the index.