Question

1. According to the Economist Big Mac index in January 2020, the British pound sterling (GBP) was 22% undervalued against the U.S. dollar. Explain what this implies based upon the theory of purchasing power parity and describe the limitations of this approach

Answer 1

Purchasing Power Parity is based on law of one price. It states that exchange rate depends on the price of same item in 2 countries. If a material cost 120 in Britain and 100 in US, that means that Britain is undervalued than US.

Hence currency exchange rate are a reflection of cost of items between 2 countries. The theory asssumes that goods are freely tradable and there is no transportation costs involved. It is an open economy.

In the given scenario, we observe that GBP is undervalued by 22%, that means to buy anything in GBP you need to pay more as compared to buy something in US. US Dollars are more valuable than GBP.

Limitations:

• Theory assumes that it is a open economy and a stable economy. The state of economy does not change. That is rarely a practical situation
• Free movement of goods and no transportation costs cannot be considered as nil, hence the theory is limited to that extent
• In the long term, such trend may be observed, but the theory is not useful to forecast short term exchange rates.