Question

Suppose a Starbucks tall latte costs $4.00 in the United States and 2.50 euros in the Euro area. Also, suppose a McDonald’s Big Mac costs $4.50 in the United States and 3.60 euros in the Euro area. If the nominal exchange rate is .80 euros per dollar, which goods have prices that are consistent with purchasing-power parity?

	a.	the tall latte but not the Big Mac
	b.	the Big Mac but not the tall latte
	c.	both the tall latte and the Big Mac
	d.	neither the Big Mac nor the tall latte

If over the next six months inflation is higher in the U.S. than in foreign countries, then according to purchasing-power parity

	a.	only the nominal exchange rate depreciates.
	b.	both the real and nominal exchange rate appreciate.
	c.	only the real exchange rate appreciates.
	d.	both the real and nominal exchange rate depreciate.

Answer 1

1. b. the Big Mac but not the tall latte.
($1 = 0.80 euro
So, Price of tall latte in euros should be 4*0.8 = 3.2 euros which does not equal 2.5 euros.
Price of big mac in euros should be (4.5)*0.8 = 3.6 euros equals actual price of 3.6 euros.)

2. a. only the nominal exchange rate depreciates.
(As US experiences inflation, nominal exchange rate will depreciate but real exchange rate will not change.)