No the exchange rate is likely to adjust in such a

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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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