Question

5. The Argentine peso was fixed through a currency board at Ps1.00/$ throughout the 1990s. In January 2002 the Argentine peso was floated. On January 29, 2003 it was trading at Ps3.65/$. During that one-year period Argentina's inflation rate was 20% on an annualized basis.

Inflation in the United States during that same period was 2.5% annualized.

1. What should have been the exchange rate in January 2003 if PPP held?

2. By what percentage was the Argentine peso undervalued on an annualized basis?

1. What were the probable causes of undervaluation?

Answer 1

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Answer:

1)

As per the given information, the purchase power parity (PPP) is being held. In this case, the beginning exchange rate that is Ps1.00/$ will only be considered for the calculation purposes.

Exchange rate changes according to PPP are determined using the below formula:

= 1.00 *(1+0.2)/(1+0.025) = Ps1.17073/$

2)

= 1.17073/3.65 - 1= -67.925%

3)

The inflatin rate being very hight at 20% is one of the main factors of undervaluation. Another factor that also has taken into consideration is the balance of payments in Argentina. It is said to have a severe crisis which is also a main contribution of undervaluation of the currency