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**Unformatted text preview: **higher price? No, the exchange rate
is likely to adjust in such a way so
that the price of a Big Mac is the
same in both cities. Now ask yourself what the
exchange rate has to be between
the dollar and yen before the Big
Mac is the same dollar price in New
York and Tokyo. Here are three different exchange rates. Pick the correct one. (a) $1
(b) $1
(c) $1 ¥133.33
¥150.00
¥89.00 The answer is (a), $1 ¥133.33. At
this exchange rate, a Big Mac in
New York is $3 (as we stated earlier), and a Big Mac in Tokyo that is
¥400 is $3 (once we have computed its price in dollars). Here are
the steps: (1) The exchange rate is $1 ¥133.33; (2) 1 yen is equal
to $0.0075; (3) $0.0075 400
yen is $3.
The purchasing power parity
theory in economics predicts that
the exchange rate between two currencies will adjust so that, in the
end, $1 buys the same amount of a
given good in all places around the
world. In other words, if the
exchange rate is initially $1 ¥100
when a Big Mac is $3 in New York
and ¥400 in Tokyo, it will change to
become $1 ¥133.33. In other
words, the dollar will soon
appreciate relative to the yen.
The Economist, a well-known
economics magazine, publishes
what it calls the “Big Mac index”
each year. It shows what
exchange rates currently are and
it shows what a Big Mac costs in
different countries (just as we
did here). Then it predicts which
currencies will appreciate and
depreciate based on this information. The Economist does not
always predict accurately, but it does
do so in many cases.
In other words, if you want to
predict whether the euro, pound, or
peso is going to appreciate or
depreciate in the next few months,
looking at exchange rates in terms
of the price of Big Mac will be a
useful source of information.
Suppose a Big Mac
costs $3 in New York
City and 4.25 Swiss francs in Zurich.
Also, suppose $1 1.25 francs.
Based on our discussion, do you
expect the franc to appreciate or
depreciate? Explain your answer.
THINK
ABOUT IT Section 3 The Exchange Rate 417 15 (390-427) EMC Chap 15 11/18/05 9:13 AM Page 418 Many people
speculate in currencies, attempting to
make a profit by buying and selling certain currencies at
opportune times.
Most people, however, are interested
in exchange rates
only when they
travel to foreign
countries. a dollar buys fewer euros than it did on
Tuesday. When this situation happens, economists say that the dollar has depreciated
relative to the euro. Depreciation is a
decrease in the value of one currency relative
to other currencies. A currency has depreciated if it buys less of another currency.
Appreciation is the opposite—an increase
in the value of one currency relative to other
currencies. A currency has appreciated if it
buys more of another currency. For example,
if the exchange rate goes from $1 for €0.80 to
$1 for €0.90, the dollar buys more euros and
therefore has appreciated in value.
Suppose the exchange rate
between the U.S. dollar and the Mexican
peso is $1 10 pesos on Wednesday. So, if
you have $1 you can get 10 pesos in
exchange for it. Suppose two days later, on
Friday, the exchange rate is $1 9 pesos; if
you have $1 you can get 9 pesos for it. The
dollar got more pesos in exchange for it on
Wednesday than on Friday. We would say,
then, that the dollar depreciated between
Wednesday and Friday.
EXAMPLE: depreciation
A decrease in the value
of one currency relative
to other currencies.
appreciation
An increase in the value
of one currency relative
to other currencies. 418 Chapter 15 International Trade and Economic Development If the Dollar Depreciates,
Foreign Goods Are More
Expensive
Suppose you and a friend take a trip to
Mexico City this summer. In Mexico City,
you come across a jacket that you want to
buy. The price tag reads 1,000 pesos; what is
the price in dollars? To find out, you need to
know the current exchange rate between the
dollar and the peso. Suppose it is $1
10
pesos; for every dollar you give up, you get 10
pesos in return. In other words, you will pay
$100 (which is the same as 1,000 pesos) to
buy the jacket. You decide to buy the jacket.
Here are the steps to the calculation: (1) the
exchange rate is $1
10 pesos; (2) if we
divide $1 by 10, we learn how much we have
to pay for 1 peso, which is 10 cents; (3) we
multiply 10 cents times 1,000 pesos, which
equals $100.
A week passes, and you and your friend
are still in Mexico City. Your friend likes
your jacket so much that he decides to buy
one, too. You and your friend return to the 15 (390-427) EMC Chap 15 11/18/05 9:13 AM Page 419 store and find the exact jacket for sale, still
for 1,000 pesos. You tell your friend that he
will have to pay $100 for the jacket.
However, you are wrong, because the dollarpeso exchange rate changed since last week.
Now it is $1 8 pesos. In other words, the
dollar has depreciated relative to the peso,
because this week each dollar buys fewer
pesos than it did last week.
What will the jacket cost in dollars this
week? The answer is $125. Here are the steps
to the calculation: (1) we know the exchange
rate is $1 8 pesos; (2) if we divide $1 by 8,
we learn how much we pay to pa...

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