Question

-What is Purchasing power parity (PPP)?

2-When are currencies overvalued or undervalued?
3-How is the PPP calculated?
4-Why is the PPP important in international business?
5-Using the data below,

a) Find the implied PPP for the Euro Area,

b) Is the Euro under or overvalued against the dollar? and by how much? (must show your calculations for credit)

Country	local_price	dollar_ex	dollar_price	implied ppp
USA	5.28	1.0	5.28	1.0
Euro area	3.95	0.8	4.84	?

Big Mac Price USA: $5.28
Big Mac Price EU: 3.95 €

Answer 1

1) Purchasing Power Parity is one of the economic theory which states that price of goods and services would be equal between countries over the time. It is a theory which compares the different countries currencies through a basket of goods approach. In short it tells that two currencies are in equilibrium or at par when the goods are priced the same in both the countries.

2) Currencies which are worth more than the Purchasing power parity are said to be undervalued and currencies which are worth less than the purchasing power parity calculation are said to be overvalued.

3) The PPP is calculated as follows :

S = P1/P2

Where S = represents exhange rate of currency 1 to currency 2

P1 = cost of goods in currency 1

P2 = cost of goods in currency 2

4) Purchasing power parity is important to calculate the growth and inflation rate of different countries. It also gives an idea about the gap between the rich and the poor. It also helps in prediction of future inflation rate. It provides stastics to calculate the gross domestic product of a country.

5)a The implied PPP for the Euro area is Local price/dollar price = 3.95/4.84 = 0.812

b) Actual exhange rate is $1 = Euro 0.80

(0.812-0.80)/0.80 * 100 = Euro is 1.50% overvalued against the U.S. Dollar