Question

6. Purchasing power parity 

Using data from The Economist's Big Mac Index for 2011, the following table shows the local currency price of a Big Mac in several countries as well as the actual exchange rate between each country and the United States. At the time of the data collection, a Big Mac would have cost you $4.07 in the United States and GBP 2.39 in the United Kingdom. The actual exchange rate between the British pound and the U.S. dollar was $1.63 per pound. The dollar price of a Big Mac purchased in the United Kingdom was, therefore, computed as follows: 

$$ \begin{aligned} \text { Dollar price of a Big Mac in the United Kingdom } &=G B P 2.39 \times \frac{\$ 1.63}{\text { GBP } 1.00} \\ &=\$ 3.90 \end{aligned} $$

For the price you paid for a Big Mac in the United States, you could have purchased a Big Mac in the United Kingdom and had some change left over for french fries!

Complete the final column of the table by computing the dollar price of a Big Mac for the countries where this amount is not given Note: Round your answers to the nearest cent. 

                                          Big Mac Index: July 25, 2011                         Local Price              Actual Exchange Rate           Dollar Price                      (Foreign currency)   (Dollars per unit of foreign currency)  (Dollars)   The Eurozone              3.44                          1.43                         4.92   India                    205.00                         0.02   United Kingdom            2.39                          1.63                      3.90   Poland                    8.63                          0.36                      3.11   China                     14.70                         0.16                      2.35

Purchasing power parity (PPP) theory states that exchange rates adjust to equalize the prices of goods in any two countries. For the dollar price of a Big Mac in the United States and the United Kingdom to be identical, a U.S. citizen would need to be able to convert $4.07 into GBP 2.39 GBP exactly To find the exchange rate at which hamburger purchasing power is the same in both countries, divide the price in the United States by the price in the United Kingdom: 

PPP Exchange Rate \((U . S .\) Dollars per British pound \()=\frac{\$ 4.07}{\text { GBP } 2.39}\) \(=\$ 1.70\) per pound

PPP Exchange Rate (U.S.Dollars per British pound) \(=\frac{\$ 4.07}{\text { GBP2.39 }}\) \(=\$ 1.70\) per pound

The exchange rate that would have equalized the dollar price of a Big Mac in the United States and the Eurozone (that is, the PPP exchange rate for Big Macs) is This change would mean that the dollar had against the euro. 

If Big Macs were a durable good that could be costlessly transported between countries, which of the following would present an arbitrage opportunity? Check all that apply. 

• Exporting Big Macs from Poland to China 

• Exporting Big Macs from the United States to the Eurozone 

• Exporting Big Macs from India to China

Answer 1