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CHAPTER3.PURCHASINGPOWERPARITYA currency is misvalued when the actual FX rate is not equal to the intrinsicFX rate. In the global business environment, the success of a manager’sstrategic decisions may well depend on whether a currency is overvalued,undervalued, or correctly valued. So managers need to understand the basicsof intrinsic FX rates.In this chapter, we cover the connection between FX rates andgoods prices, and the role of goods prices in intrinsic FX rates. You will learnaboutlong-runintrinsic FX rates based on purchasing power.FXRATECHANGESANDFOREIGNDEMANDFORGOODSIn principle and other things the same in a flexible FX rate system, a drop inthe foreign demand for a country’s products tends to lead to a drop in the FXprice of the country’s currency, and vice versa. Now let’s think about the otherdirection. How do FX rate changes affect foreign demand for a country’sgoods products?
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Japanese products should drop. The rise in the FX price of the yen (relativeto the US dollar) makes Japanese products more expensive to U.S. buyers.As well, U.S. products become less expensive to Japanese buyers, and thusU.S. exports to Japan are likely to increase.If the spot FX rate changes from 1.25 Sf/$ today to 1.35 Sf/$, and other things stay thesame, U.S. goods imports from Switzerland are likely to a) increase or b) decrease.Answer: a. The FX price of the Swiss franc has fallen, making Swiss products