Question

Calculate the real exchange rates (for the US) for the cases below. Does Purchasing power parity hold in the examples below?

a) A Toyota Camry costs $25,000 in the US whereas it costs €22,000 in Germany. The nominal exchange rate is €0.8/$.

b) An English breakfast costs £5 in England whereas it costs $8 in the US. The nominal exchange rate is £0.75/$.

c) An identical hat costs $5 in the US and 100 pesos in Mexico. The nominal exchange rate is 20 pesos/$.

Answer 1

Real exchange rate (RER) = Price in Foreign country (currency) / Price in US (dollar)

(a)

RER = 22,000 / 25,000 = €0.88/$

Since RER > Nominal exchange rate, Purchasing power parity does not hold.

(b)

RER = 5 / 8 = £0.625/$

Since RER < Nominal exchange rate, Purchasing power parity does not hold.

(c)

RER = 100 / 5 = Peso 20/$

Since RER = Nominal exchange rate, Purchasing power parity holds.