purchasing power parity

• According to economists, what should the exchange rate between two currencies reflect?

  Purchasing power parity
• What does purchasing power parity (PPP) imply about the cost of a basket of goods in different countries?

  It should be the same when converted
• If a basket of goods costs £1,000 in the UK and $1,600 in the US, what exchange rate reflects purchasing power parity?

  £1 = $1.60
• What happens if the US basket increases to $1,700, while the exchange rate remains at £1 = $1.60?

  Exchange rate doesn't reflect purchasing power
• If £1,000 converts to $1,600, but the US basket costs $1,700, is the pound overvalued or undervalued?

  Undervalued
• What is the implication of the pound being undervalued against the dollar in this scenario?

  It buys less in the US
• If the pound is undervalued, what is the dollar, therefore?

  Overvalued
• Why do economists prefer using the real exchange rate over the nominal exchange rate for measuring purchasing power?

  It accounts for changes in prices
• What does the real exchange rate tell you about currencies?

  Purchasing power parities
• In theory, what should happen to nominal exchange rates if they are undervalued or overvalued?

  They should self-adjust
• In a floating exchange rate system, what should exchange rates adjust to reflect?

  Purchasing power parity
• If the dollar is overvalued against the pound, what might US consumers do?

  Buy UK goods and services
• How should increased demand for the pound affect its value?

  Lead to appreciation
• What factor dominates exchange rates in reality?

  Speculative flows
• What can speculation do to an undervalued or overvalued currency?

  Maintain it
• Why do economists look at real exchange rates in the real world?

  To gauge purchasing power parity
• What is the Big Mac Index?

  An index for purchasing power parity
• What is compared in the Big Mac Index?

  Price of a Big Mac
• According to the text, what was the approximate price of a Big Mac in the USA in February 2015?

  $4.74
• If a Big Mac costs $7.54 in Switzerland when converted to US dollars, is the Swiss franc overvalued or undervalued?

  Overvalued
• If a Big Mac costs $2.44 in China when converted to US dollars, is the Chinese Yuan overvalued or undervalued?

  Undervalued
• According to the Big Mac Index, what should happen to the Chinese currency in theory?

  Appreciate
• What should happen to the Frank according to the Big Mac index?

  Depreciate
• What does the Big Mac index imply if the Big Mac price is more than what the Big Mac price is in in the USA?

  Overvalued currency