What is Purchasing Power Parity, what prediction does it make? If the actual exc

Question

What is Purchasing Power Parity, what prediction does it make? If the actual exchange rate is greater than the exchange rate implied by the relative price of goods in the foreign/domestic country, then you woukd say that the domestic currency is overvalued. (That is, if the implied exchange rate is 4 francs/dollar, but the actual exchange rate is 5 francs/dollar, then the dollar is overvalued) If a Big Mac costs 3500 yen, and 5.50 dollars, what is the implied exchange rate in terms of yen/dollar? If the actual exchange rate is 700 yen/dollar, is the yen over or under valued? 888,4 3 4

Explanation / Answer

Purchasing power parity compares the purchasing powers of different currencies. In order to be achieve equal PPP the price of a particular good should remain same when both the currencies are converted to a common currency. Purchasing power parity is often used to calculate the income levels of two counteries. It predicts the value of currency changes of a country.

False. The currency is undervalued. Because if according to implied exchnage rate 4 francs equal 1 dollar and real exchange rate is 5 francs per dollar then franc is undervalued. Because 1 extra franc is being demanded.

If a big mac costs 3500 yen and 5.50 dollars, implied exchange rate = 3500/5.50 = 636 yen per dollar.

If the actual exchange rate is 700 yen per dollar then yen is under valued. Because for each dollar one has to pay 636 yens which is less than the exchange rate of 700 yens per dollar.

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