Chapter 29, Problem 1DQ

To determine

The reason why it is incorrect to say that the cost of living in Europe is very high.

Explanation of Solution

• When one visits Paris and spends money there, one feels that the cost of living is very high in Europe, as compared to the U.S. But one’s assumption is not correct because of the exchange rate effect.

• When money spent is converted into dollars it seems to be very high as the value of Euro is more as compared to the dollar. However, the average wage in Paris is more than that in the U.S.

• Two countries have the same cost of living if the exchange ratio is 1, provided the inflation is same in both the countries.

• Thus, the reasoning that the cost of living is high in Europe is wrong as the cost of living in terms of Euro is not high.

Economics Concept Introduction

Concept introduction:

Exchange rate:

When the price of one currency is expressed in another currency then it is referred to as an exchange rate. It is determined from the word supply and demand for currency. It is an indirect function of non-traded goods. It does not take into consideration the non-traded goods and services. Hence, it sometimes overestimates the cost of living.