Defining the Real Exchange Rate The real exchange rate between the US foreign

Defining the real exchange rate the real exchange

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Defining the Real Exchange Rate The real exchange rate between the U.S. & foreign country is… $ price of foreign basket of goods & services relative to the $ price of U.S. basket of goods & services, or, q US/FC = ( E $/fc x P FC )/ P US Real $ depreciation { fall in dollar’s purchasing power over foreign goods relative to purchasing power over U.S. goods P US declines relative to ( E $/ x P EU ), so q US/EU increases Real $ appreciation { rise in dollar’s purchasing power over foreign goods relative to purchasing power over U.S. goods P US rises relative to ( E $/ x P EU ), so q US/EU decreases 11/2/2015 Econ 181/282 F15 -- Lec 11, KOM Ch. 16 35
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LoOP, q & the Big Mac Index (1) The Economist magazine’s “Big Mac Index” is an application of the Law of One Price to the McDonald’s Big Mac hamburger Want to see extent to which exchange rates really do adjust to equalize prices across countries Method Get prices of Big Macs for set of countries Get market exchange rates (local currency/$) for same countries With U.S. Big Mac as reference, construct implied PPP exchange rate (local price per US price) Subtract actual exchange rate from implied PPP exchange rate & divide by actual exchange rate to get % measure of currency overvaluation/undervaluation against dollar 11/2/2015 Econ 181/282 F15 -- Lec 11, KOM Ch. 16 36
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LoOP, q & the Big Mac Index (2) 11/2/2015 Econ 181/282 F15 -- Lec 11, KOM Ch. 16 37 Take Brazil (2009): Implied PPP E = P BigMac BR / P BigMac US = 2.27 reals/dollar Actual E = 2.32 R/$ Undervaluation of real against $ = (2.27 – ±²³±´µ±²³± § -2% The $ price of a Brazilian Big Mac is roughly 2% less than its U.S. price. Î Brazilian goods are cheap relative to U.S. goods Î Visit Brazil!
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Do-It-Yourself Big Mac Index (1) Let U.S. price of Big Mac be $4.50 Let London price of Big Mac be £2.25 Let market E $/£ = $2.10/£ What is implied PPP exchange rate, in $/£ ? 11/2/2015 Econ 181/282 F15 -- Lec 11, KOM Ch. 16 38
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Do-It-Yourself Big Mac Index (2) Let U.S. price of Big Mac in U.S. be $4.50 Let London price of Big Mac be £2.25 Let market E $/£ = $2.10/£ What is implied PPP exchange rate, in $/£ ? Implied PPP E $/£ = $4.50 / £2.25 = $2/£ 11/2/2015 Econ 181/282 F15 -- Lec 11, KOM Ch. 16 39
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Do-It-Yourself Big Mac Index (3) Let U.S. price of Big Mac in U.S. be $4.50 Let London price of Big Mac be £2.25 Let market E $/£ = $2.10/£ What is implied PPP exchange rate, in $/£ ? Implied PPP E $/£ = $4.50 / £2.25 = $2/£ Is the $ undervalued or overvalued vis-à-vis the £? 11/2/2015 Econ 181/282 F15 -- Lec 11, KOM Ch. 16 40
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