Presentation

1. Suppose that you have the following data on exchange rates and prices:

E P PF

2005 .49 100 100

2006 .52 106 102

2007 .55 112 104

2008 .56 115 105

2009 .60 120 106

a. Calculate the percentage change in E, P, and PF for each of the years after 2005.

Year %changeE %changeP %changePF

2006 6.12 6 2

2007 5.77 5.66 1.96

2008 1.82 2.68 0.96

2009 7.14 4.35 0.95

b. Where was inflation higher (home or overseas) over the sample period?

Inflation is higher at home.

c. How well does relative PPP hold in this example?

Relative PPP approximately holds for 2007-08 only.

Suppose that a Big Mac costs $5.00 in New York and SF30 in Geneva. Suppose further that the price of 1SF on that day is $0.20. Calculate the purchasing power parity exchange rate between the Swiss franc and the dollar. Based on your calculation, is the SF overvalued or undervalued? Explain. Suppose now that a Big Mac costs 1.25 pounds in London while the spot rate exchange rate is $2.50. Is the pound overvalued or undervalued? Explain. Is the Big Mac a good basis for PPP calculations? Why or why not?

The PPP exchange rate is 30/5  6. So, the Swiss franc is undervalued (the dollar is overvalued, as you should only get 5 SF per one dollar, instead of the 6 you currently get).

In the US-UK case, the PPP exchange rate is 1.25/5 = 0.25. Thus, the British pound is overvalued (the dollar is undervalued as you should get 0.40 pounds per dollar, instead of only 0.25).

To some extent, since the Big Mac is very much the same good all over the world, then this index is useful. In reality, differences in product features, transport costs, tariffs and consumer tastes will cause deviations from PPP.

Suppose that on January 1, the price of one hundred yen was $0.80 and PPP held. Over the year, the Japanese inflation rate was 5 percent and the U.S. inflation rate was 10 percent. If the exchange rate at the end of the year was $0.90, does the yen appear to be overvalued, undervalued, or at the PPP level? Explain your answer.

According to PPP theory, the exchange rate between the yen and dollar will adjust to compensate for any inflation differential between the two countries. In the example, the U.S. inflation rate is 5 percentage points higher than the Japanese rate, so the value of the dollar should fall by 5 percent relative to the yen. Such an adjustment would place the exchange rate at $0.84 per 100 yen. If the actual rate at year’s end is $0.90 per 100 yen, then the dollar would be undervalued and the yen overvalued in relation to their PPP levels.

Suppose at the beginning of the year, a textbook book sells for €60 in Paris, France, and $60 in New York City, and PPP holds. Over the year, there is an inflation rate of 10 percent in France and no inflation in the United States. What exchange rate would maintain PPP at the end of the year?

Initially, PPP would hold at an exchange rate of €60/$60  1. If prices in France rose 1.1 times the price in the U.S., then the new PPP value would be $1  €1.1.