Solution_set1 - ECON 321, International Monetary Theory,...

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ECON 321, International Monetary Theory, Spring 2006 Arslan Razmi Answers to Problem Set 1 1. Tall Latte Index Big Mac Index All prices in US$ P P/P US P P/P US US 2.80 1.00 2.90 1.00 Switzerland 4.54 1.62 4.90 1.69 EU 3.72 1.33 3.28 1.13 UK 3.28 1.17 3.37 1.16 Hong Kong 3.22 1.15 1.54 0.53 Japan 3.16 1.13 2.33 0.80 South Korea 2.97 1.06 2.72 0.94 Turkey 2.97 1.06 2.58 0.89 Singapore 2.86 1.02 1.92 0.66 China 2.77 0.99 1.26 0.43 Australia 2.69 0.96 2.27 0.78 Taiwan 2.66 0.95 2.24 0.77 New Zealand 2.46 0.88 2.65 0.91 Mexico 2.38 0.85 2.08 0.72 Canada 2.35 0.84 2.33 0.80 Malaysia 2.10 0.75 1.33 0.46 Thailand 1.93 0.69 1.45 0.50 Mean 1.03 0.83 Standard deviation 0.22 0.31 If absolute PPP were to hold, we would expect the relative prices of each good to be exactly the same in all countries when measured in the same currency. In other words, we would expect that P/P US = 1 across the board. However, the table above demonstrates that that is not true for the Big Mac or for the Tall Latte. The same conclusion can be derived from the graphs below. Absolute PPP does not seem to hold in this case. However, the average price of Tall Lattes is much closer to obeying absolute PPP than that of Big Macs. Also, the standard deviation of the relative price of Tall Lattes is less that of Big Macs, again indicating that the pricing behavior of Tall Lattes is much more consistent with absolute PPP. Also, while the average Tall Latte index indicates that other exchange rates are on average overvalued against the dollar, the Big Mac index indicates that they are on average undervalued. The difference for China is particularly interesting. The relative PPP approach hypothesizes that relative prices of commodities will be constant over time , i.e., P/P US = constant over time, although not necessarily 1. Thus, the relative PPP approach is a weaker version of the absolute PPP one. Since we only have data for one year, we cannot say anything about whether or not relative PPP holds for Tall Lattes and Big Macs. Absolute and/or relative PPP does not generally hold up very well in the real world.
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This note was uploaded on 05/07/2008 for the course ECONOMICS 321 taught by Professor Razmi during the Spring '08 term at UMass (Amherst).

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Solution_set1 - ECON 321, International Monetary Theory,...

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