1. According to the theory of purchasing power parity (PPP), what will happen to
ID: 1195286 • Letter: 1
Question
1. According to the theory of purchasing power parity (PPP), what will happen to the value of the dollar (against foreign currencies) if the U.S. price level doubles and price levels in other countries remain constant? Why is the theory more suitable to analyzing events in the long run? 2. The Big Mac Price Index computed by the Economist has consistently found the U.S. dollar to be undervalued against some currencies and overvalued against others, which seems to call for a rejection of the purchasing power parity theory. Explain why the index may not be a valid test of the theory
Explanation / Answer
According to purchasing power theory of exchange rate, the exchange rate adjusts so that an identical good in two different countries has the same price when expressed in the same currency.
S=P1/P2
Where P1 is the average price of all goods and services in coutry 1
P2 is average price of goods and services in country 2
S represents country exchange rate of currency 1 wrt to country’s 2
When Us price level doubles then S will double which means exchange rate must double to make the relative purchasing power in two countries same.
In long run, economy adjusts to the real variable compared to nominal one. Actual cost of production and price level are efficient indicator for judging the standard of living in two countries which must have final impact on calculation of exchange rate.
Index is not valid test for theory because:
1: exchange rate is calculated on the basis of basket of goods and services, and Big mac index is insufficient indicator to judge the variation in average price level in economy.
2. Exchange rate must depends on the basket of tradable goods and services while Big mac index overestimate the movement of price in some countries and underestimate for others.
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