Question

The table below provides data for 3 countries for the Big Mac Index as published by the Economist magazine.

Exchange Rate (LCU/USD) 1.00 Price (in Local Currency Units) Price (in USD) Country United States 4.30 4.30 70 16.97 4.13 Mexico 4.53 5.90 1.30 Canada

Based on the table, answer the following questions.

(a) What is the real exchange rate between Mexican Peso (ARS) and United States Dollar (USD), i.e. qARS/USD?

(b) Is the Canadian Dollar over-valued or under-valued with respect to the Mexican Peso? By how much?

(c) Does absolute purchasing power parity hold between Mexico and United States? Why or why not?

Answer 1

Solution- (a)

The real exchange rate compares the purchasing power of different currencies to each other, i.e. Subject to the exchange rates between two currencies, what is their relative purchasing power for a basket of goods (In our case the Big Mac index). It is calculated as follows:

Real exchange rates= (Nominal exchange rate between two currencies*Price of goods in first currency)/price of goods in second currency

Real exchange rate (USD to ARS)= (16.97*4.3)/70= 1.042

Solution- (b)

A purchaser will have to spend USD 4.13 in Mexico to buy Big mac mac index, whereas he will have to spend USD 4.53 in Canada for the same. Therefore, a buyer of big mac index in Canada can buy 1.097 big mac index (calculated as 4.53/4.13) in Mexico.

Therefore, a Canadian dollar can purchase more in Mexico than what it does in Canada, hence it can be said that Canadian dollar is overvalued against Mexican Peso

Calculation of real exchange rate between Canadian dollar and mexican peso= {(16.97/1.3)*5.9}/70= 1.0999

Therefore, Canadian dollar is overvalued by 10% [i.e. (1.0999-1)*100]

Solution- (c)

Absolute purchasing power parity theorem is based on the concept of consistency in prices across various countries, i.e. subject to the existing nominal exchange rates, the goods should cost same in one country compared to another country. When this holds true, the real exchange rate of two currencies is equal to 1.

However, as we see in part (a), the real exchange rate between USD and ARS is 1.042 which means that USD can buy more of big mac index in Mexico as compared to United States, which shows that the interest rate parity doesn't hold true between Mexico and United States.