Chapter 20, Problem 2WE

To determine

The Local prices, exchange rate and PPP across the countries.

Concept Introduction:

Purchasing Power Parity(PPP)- The theory is based on the metric of purchasing power to assess the currency rate equilibrium on the foreign exchange market. Two currencies are compared using the basket of goods approach. Two currencies are said to be in equilibrium if the local prices of the basket of goods are the same in both the countries.

Explanation of Solution

Apart from the International Comparisons Program (ICP) established in 1968, the annual test of PPP tracks the annual price of Mc Donald’s Corporation (MCD) Big Mac burger in many countries since 1986. In this PPP the price of the Big Mac is the benchmark and the hamburger replaces the basket.

The PPP would be the ratio of local prices in a country to the dollar price of the basket. This is also the expected rate of exchange. Is the actual rate of exchange is higher than this, the dollar is said to be overvalued and if the rate of exchange is lower dollar is said to be undervalued.

Part (a)

The graph below establishes a relationship between the local price, the expected rate of exchange or the PPP and the actual rate of exchange between the dollar and the local currency on the data sourced from the Big Mac PPP index.

Country	Local Price	Actual Dollar Exchange Rate	Expected Exchange Rate or the PPP
Argentina	75	18.9	14.2
Australia	5.9	1.3	1.1
Brazil	16.5	3.2	3.1
Britain	3.19	0.7	0.6
Canada	6.55	1.2	1.2
Chile	2600	605.9	492.4
China	20.4	6.4	3.9
Colombia	10900	2844.1	2064.4
Costa Rica	2290	568.5	433.7
Czech Republic	79	20.7	15.0
Denmark	30	6.1	5.7
Egypt	34.21	17.7	6.5
Euro area	3.95	0.8	0.7
Hong Kong	20.5	7.8	3.9
Hungary	864	252.1	163.6
India	180	63.9	34.1
Indonesia	35750	13359.0	6770.8
Israel	16.5	3.4	3.1
Japan	380	110.7	72.0
Latvia	2.7	0.8	0.5
Lithuania	2.8	0.8	0.5
Malaysia	9	4.0	1.7
Mexico	48	18.7	9.1
New Zealand	6.2	1.4	1.2
Norway	49	7.9	9.3
Pakistan	375	110.5	71.0
Peru	10.5	3.2	2.0
Philippines	134	50.7	25.4
Poland	10.1	3.4	1.9
Russia	130	56.7	24.6
Saudi Arabia	12	3.8	2.3
Singapore	5.8	1.3	1.1
South Africa	30	12.3	5.7
South Korea	4400	1069.3	833.3
Sri Lanka	580	153.8	109.8
Sweden	49.1	8.0	9.3
Switzerland	6.5	1.0	1.2
Taiwan	69	29.6	13.1
Thailand	119	32.0	22.5
Turkey	10.75	3.8	2.0
UAE	14	3.7	2.7
Ukraine	47	28.7	8.9
United States	5.28	1.0	1.0
Uruguay	140	28.6	26.5
Vietnam	65000	22711.5	12310.6
Austria	3.4	0.8	0.6
Belgium	4.1	0.8	0.8
Estonia	3.15	0.8	0.6
Finland	4.56	0.8	0.9
France	4.2	0.8	0.8
Germany	3.9	0.8	0.7
Greece	3.35	0.8	0.6
Ireland	4.07	0.8	0.8
Italy	4.2	0.8	0.8
Netherlands	3.71	0.8	0.7
Portugal	3.2	0.8	0.6
Spain	3.95	0.8	0.7

Country Local Price Actual Dollar Exchange Rate Expected Exchange Rate or the PPP Argentina 75 18.9 14.2 Australia 5.9 1.3 1.1 Brazil 16.5 3.2 3.1 Britain 3.19 0.7 0.6 Canada 6.55 1.2 1.2 Chile 2600 605.9 492.4 China 20.4 6.4 3.9 Colombia 10900 2844.1 2064.4 Costa Rica 2290 568.5 433.7 Czech Republic 79 20.7 15.0 Denmark 30 6.1 5.7 Egypt 34.21 17.7 6.5 Euro area 3.95 0.8 0.7 Hong Kong 20.5 7.8 3.9 Hungary 864 252.1 163.6 India 180 63.9 34.1 Indonesia 35750 13359.0 6770.8 Israel 16.5 3.4 3.1 Japan 380 110.7 72.0 Latvia 2.7 0.8 0.5 Lithuania 2.8 0.8 0.5 Malaysia 9 4.0 1.7 Mexico 48 18.7 9.1 New Zealand 6.2 1.4 1.2 Norway 49 7.9 9.3 Pakistan 375 110.5 71.0 Peru 10.5 3.2 2.0 Philippines 134 50.7 25.4 Poland 10.1 3.4 1.9 Russia 130 56.7 24.6 Saudi Arabia 12 3.8 2.3 Singapore 5.8 1.3 1.1 South Africa 30 12.3 5.7 South Korea 4400 1069.3 833.3 Sri Lanka 580 153.8 109.8 Sweden 49.1 8.0 9.3 Switzerland 6.5 1.0 1.2 Taiwan 69 29.6 13.1 Thailand 119 32.0 22.5 Turkey 10.75 3.8 2.0 UAE 14 3.7 2.7 Ukraine 47 28.7 8.9 United States 5.28 1.0 1.0 Uruguay 140 28.6 26.5 Vietnam 65000 22711.5 12310.6 Austria 3.4 0.8 0.6 Belgium 4.1 0.8 0.8 Estonia 3.15 0.8 0.6 Finland 4.56 0.8 0.9 France 4.2 0.8 0.8 Germany 3.9 0.8 0.7 Greece 3.35 0.8 0.6 Ireland 4.07 0.8 0.8 Italy 4.2 0.8 0.8 Netherlands 3.71 0.8 0.7 Portugal 3.2 0.8 0.6 Spain 3.95 0.8 0.7