If q usf 1 then the basket in the home country is

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If q US/F 1, then the basket in the home country is more expensive than the bas- ket in the United States. This implies the U.S. dollar is undervalued and the Home currency is overvalued. According to PPP, the Home country will experience a real depreciation (Brazil and India). 4. Table 3-1 in the text shows the percentage undervaluation or overvaluation in the Big Mac, based on exchange rates in July 2009. Suppose purchasing power parity holds in the long run, so that these deviations would be expected to disappear. Sup- pose the local currency prices of the Big Mac remained unchanged. Exchange rates in January 4, 2010, were as follows (source: IMF): Solutions Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run S-13 Country Per U.S. $ Australia (A$) 0.90 Brazil (real) 1.74 Canada (C$) 1.04 Denmark (krone) 5.17 Eurozone (euro) 0.69 India (rupee) 46.51 Japan (yen) 93.05 Mexico (peso) 12.92 Sweden (krona) 7.14 Based on these data and Table 3-1, calculate the change in the exchange rate from July to January, and state whether the direction of change was consistent with the PPP-implied exchange rate using the Big Mac Index. How might you explain the failure of the Big Mac Index to correctly predict the change in the nominal exchange rate between July 2009 and January 2010?
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Answer: (The complete table is included in the Excel workbook for this chap- ter in the solutions manual.) S-14 Solutions Chapter 3 Exchange Rates I: The Monetary Approach in the Long Run Exchange rate (local currency Big Mac prices per U.S. dollar) Exchange Percent Over (+) / rate actual change under (–) Jan. 4, July 13, Actual, valuation 2010 (local 2009– In local In U.S. Implied July against currency Jan. 4, PPP correct currency dollars by PPP 13th dollar, % per U.S. $) 2010 or not? (1) (2) (3) (4) (5) United States $ 3.57 3.57 Australia A$ 4.34 3.3643 1.2157 1.29 –5.76% 0.90 –30.23% Correct direction, but depreciation was way more than predicted. Brazil R$ 8.03 4.0150 2.2493 2 12.46% 1.74 –13.00% PPP predicted depreciation, but currency actually appreciated. Canada C$ 3.89 3.3534 1.0896 1.16 –6.07% 1.04 –10.34% Correct direction, but appreciation was way more than PPP predicted. Denmark Kr 29.50 5.5243 8.2633 5.34 54.74% 5.17 –3.18% PPP predicted [ic] depreciation, but currency actually appreciated. Euro area 3.31 4.5972 0.9272 0.72 28.77% 0.69 –4.17% PPP predicted depreciation, but currency actually appreciated. Japan ¥ 320.00 3.4557 89.6359 92.6 –3.20% 93.05 0.49% PPP predicted appreciation, but currency actually depreciated. Mexico Peso 33.00 2.3913 9.2437 13.8 –33.02% 12.92 –6.38% Correct direction, but appreciation was way less than PPP predicted. Sweden Kr 39.00 4.9367 10.9244 7.9 38.28% 7.14 –9.62% PPP predicted [ic] depreciation, but currency actually appreciated.
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We can see from the table that during this time, PPP correctly predicted the di- rection exchange rate movements for only three of these countries. The Big Max Index may fail to predict exchange rate movements because there are nontrad- able inputs used in the production of Big Macs, such as labor and rent.
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