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Answer the following questions related to the predictions of PPP:

(a) What are the predictions of the PPP theory regarding real exchange rates?

(b) Discuss why the empirical support for PPP and the law of one price is weak in recent data.

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Chika Ilonah
Chika IlonahLv10
29 Sep 2019

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Related questions

In the long run, exchange rates reflect purchasing power parity (PPP). This theory called the law of one price, aggregates and generalizes the idea that the same good must sell for the same price, in the same currency units, regardless of where it is produced. The following questions consider how PPP and the law of one price work and whether they can explain long-run exchange rate movements.

PPP may not hold because:

A. The law of one price applies, on average, to all goods.

B. Countries are gradually reducing trade restrictions.

C. All goods and services can trade at a relatively low cost.

D. Goods produced in different countries vary greatly in quality.

Large-scale wars typically bring a suspension of international trading and financial activities. Exchange rates lose much of their relevance under these conditions, but once the war is over, governments wishing to fix exchange rates face the problem of deciding what the new rates should be. The PPP theory has often been applied to this problem of postwar exchange rate realignment. Imagine that you are a British Chancellor of the Exchequer and that World War I has just ended. Explain how you would figure out the dollar/pound exchange rate implied by PPP. When might it be a bad idea to use the PPP theory in this way?

1) The price of a Big Mac in the U.S. is $3.45 and the price in Mexico is Peso 27.0. What is the implied PPP of the Peso per dollar?

A) Peso 8.50/$1

B) Peso 10.8/$1

C) Peso 11.76/$1

D) None of the above

2) Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is 8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso 7.80/$1. Thus, according to PPP and the Law of One Price, at the current exchange rate the peso is:

A) overvalued.

B) undervalued.

C) correctly valued.

D) There is not enough information to answer this question.

3) According to the Big Mac Index, the implied PPP exchange rate is Mexican peso 8.50/$1 but the actual exchange rate is peso 10.80/$1. Thus, at current exchange rates the peso appears to be ________ by ________.

A) overvalued; approximately 21%

B) overvalued; approximately 27%

C) undervalued; approximately 21%

D) undervalued; approximately 27%

E) None of the Above

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