Overvalued/undervalued currencies. Current price of Big Mac sandwich in Switzerland is 6.5 francs (SFr) and in...

Overvalued/undervalued currencies. Current price of Big Mac sandwich in Switzerland is 6.5 francs (SFr) and in US is $5.58. a) What is the fundamental value of dollar against Swiss franc?b) Look up the current exchange rate between dollar and Swiss franc (be careful about units). Is dollar overvalued or undervalued? Based on this, can you make predictions to what should happen franc in the long-run?

Expert Solution

A. According to PPP, law of one price the exchange rate should be

Or, 1 Swiss Franc = $ 0.8585

B. Current exchange rate between US $ and Swiss Franc is

$ 1 = 0.96 Swiss Franc.

Or, 1 Swiss Franc = $ 1.04

When we compare the two exchange rate we can see that as per PPP 1 swiss franc cam buy only $ 0.8585 but in actual market 1 Swiss franc can buy $ 1.04.

Therefore, the Swiss franc is overvalued.

Similarly, we can interpret for US $. As we can see under PPP we have to spend $ 0.8585 to buy 1 swiss franc but in reality we have to pay $ 1.04 for 1Swiss franc. Therefore, US $ is undervalued.

In the long run the demand for Swiss franc will decline therefore as a result of which the exchange price will move towards the equilibrium that is where it is neither undervalued nor, overvalued.

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Rahul Sunny answered 2 years ago

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