International parity conditions 1

The price of a Big Mac in the U.S. is $3.41 and the price in Mexico is Peso 29.0. What is the implied PPP of the Peso per dollar?

• Peso 8.50/$1

• Peso 10.8/$1

• Peso 11.76/$1

• None of the above

According to the Big Mac Index, the implied PPP exchange rate is Mexican peso 8.50/$1 but the actual exchange rate is peso10.80/$1. Thus, at current exchange rates the peso appears to be ________ by ________.

• overvalued; approximately 21%

• overvalued; approximately 27%

• undervalued; approximately 21%

• undervalued; approximately 27%

One year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$1. Since that time the rate of inflation in the U.S. has been 4% greater than that in Canada. Based on the theory of Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be approximately:

• $0.96/C$

• $1/C$

• $1.04/C$

• Relative PPP provides no guide for this type of question.

Two general conclusions can be made from the empirical tests of purchasing power parity (PPP):

• PPP holds up well over the short run but poorly for the long run, and the theory holds better for countries with relatively low rates of inflation.

• PPP holds up well over the short run but poorly for the long run, and the theory holds better for countries with relatively high rates of inflation.

• PPP holds up well over the long run but poorly for the short run, and the theory holds better for countries with relatively low rates of inflation.

• PPP holds up well over the long run but poorly for the short run, and the theory holds better for countries with relatively high rates of inflation.

Given a home country and a foreign country, purchasing power parity suggests that:

• The home currency will appreciate if the current home inflation rate exceeds the current foreign inflation rate.

• The home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate.

• The home currency will depreciate if the current home inflation rate exceeds the current foreign interest rate.

• The home currency will depreciate if the current home interest rate exceeds the current foreign interest rate.