World Bank classifies economies on the basis of their gross national income (GNI) per capita. The globalization of economies would necessarily lead to a perfect market situation where in the long run exchange rates should move towards the same price of a basket of goods and services in different countries; that is, a dollar should buy the same basket of goods and services everywhere in the world. This is called purchasing power parity (PPP).
The Economist newspaper has derived a couple of innovative ways to measure the shift towards a more globalized world. The Big Mac Index was introduced in 1988. The Big Mac is produced in more than 120 countries. The theory of PPP will suggest that hamburgers cost the same in Asia as in other continents. Comparing actual exchange rates with PPP will thus provide an indication of whether a currency is under- or overvalued.
The newspaper subsequently introduced the Starbucks Tall Latte Index, in order to further test the theory of PPP. By coincidence, the average price of a Starbucks tall latte in the U.S. was the same as the average price of a Big Mac — USD 2.80 — in 2004. It turns out that the Tall Latte Index tells broadly the same story as the Big Mac Index for most key currencies. The indices show that the euro is about 30 percent overvalued against the dollar. This is based on the average price of EUR 2.93 — USD 3.70 — in member countries where Starbucks operates. Sterling pound is also 17 percent overvalued. Both indices show that the Swiss franc is the world’s most overvalued currency. The Canadian, Australian, and New Zealand dollars are still undervalued against the dollar despite their recent climb.
The indices, however, show mixed results when it comes to Asian currencies. The Big Mac Index says the yen is 12 percent undervalued against the dollar while the Tall Latte Index suggests that it is 13 percent overvalued. More startling is the Chinese yuan. It is 56 percent undervalued according to the Big Mac Index, but spot on its dollar PPP according to the Tall Latte Index. The differences probably reflect the different nature of competition in the markets for the two products: Starbucks coffee is pitched as a lifestyle drink and hence commands a premium, especially in Asian economies.
For more information, refer to Fundamentals of International Business: 1st Asia-Pacific edition by Michael Czinkota et al.