The Big Mac index was invented by the British news magazine The Economist in 1986 as a half-serious guide to whether currencies are at their “correct” level. It’s based on the theory of purchasing power parity (or PPP), which is the idea that in the long run, exchange rates should move toward the rate that would equalize the price of an identical basket of goods and services (in this case, a hamburger) in any two countries.
For example, the average price of a Big Mac in the US in July 2016 was $5.04; in China it was only $2.79 at market exchange rates. So the Big Mac index says that the yuan was undervalued by 45% ((2.79 – 5.04)/5.04) at that time.
The Big Mac Index isn’t intended to be a precise gauge for measuring currency rate discrepancies, just a tool to make the economic theory behind exchange rates more easily understood.
More recently, the Economist has created an adjusted Big Mac index, to address the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labor costs are lower.
While Purchasing Power Parity signals where exchange rates should be heading in the long run, as a country like China gets richer, it says little about today’s equilibrium rate.
The relationship between prices and GDP per person may be a better guide to the current “fair” value of a currency. The Economist’s adjusted index uses the “line of best fit” between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country, given its income per person, and its actual price gives a measure of currency under- and over-valuation.
The Economist’s chart is interactive, and you can explore it here: