Question

Suppose that a Big Mac costs $5.00 in New York and SF30 in Geneva. Suppose further exchange rate is $/ = $0.20/1SF.

a.Calculate the purchasing power parity exchange rate between the Swiss franc and the dollar.

b. Based on your calculation, is the SF overvalued or undervalued? Explain.

c. Suppose now that a Big Mac costs 1.25 pounds in London while the spot rate exchange rate is $2.50. Is the pound overvalued or undervalued? Explain.

d. Is the Big Mac a good basis for PPP calculations across the three countries? Why or why not?

e. Suppose that domestic money demand is falling at 2% per year while the money supply is rising at 6% per year. What is happening to the domestic price level? Explain in one sentence.

Answer 1

Solving first four parts as per policy:

(a) As per PPP: Big Mac costs $5 in US and SF 30 in Geneva. Hence, 30SF= 5$, which gives $1= 6SF, or 1SF = 1/6 $
(b) Market Exchange Rate is 0.2$/1 SF, or $1 for 5 SF. Hence, mkt rate for SF is overvalued, i.e. it should be valued at 1/6 per USD, but it is currently at 1/5 per USD.

(c)  1.25 pounds in London, Spot ER= $2.5 per pound. Hence, price of Burger in UK in USD= 1.25* 2.5 = 3.125. But, it is $5 in New York. Hence, currency in UK is Undervalued

PRO TIP: I have used two different methods to calculate here. Request you to try the question using both methods. This way you will be able to verify!

(d) Big Mac is not the best index because
1. It comprises a limited number of items, that too only food items.
2. Consumer sin US, Switzerland,UK etc may not value the burger in the same way. For some, it will be highly desirable, while for some others it may not be.
3. Cos of producing a big mac may be different in each country: Labour Costs, cost of inputs etc.