Question

Assume that Big Mac costs $6.50 in the U.S. and £5 in the U.K. Find the implied absolute PPP exchange rate. If the actual exchange rate $/£ = 1.4505, then according to absolute PPP, which of the following statements is correct?

The pound is undervalued relative to the dollar.
The pound is overvalued relative to the dollar.
It costs more in pounds to buy Big Mac in the U.S.
It costs the same in dollars to buy Big Mac in the U.K.
Absolute PPP holds between the U.S. and the U.K.

Answer 1

According to absolute PPP, the pound is overvalued relative to the dollar because the actual exchange rate is higher than the PPP exchange rate derived from the cost of a Big Mac in both countries.

Step-by-step explanation:

The implied absolute PPP (Purchasing Power Parity) exchange rate can be found by dividing the cost of a Big Mac in the U.S. ($6.50) by the cost in the U.K. (£5.00), which results in an exchange rate of $1.30/£1 (6.50/5 = 1.30). Comparing this to the actual exchange rate of $1.4505/£1, we can say that if the actual exchange rate is higher than the PPP rate, the currency, in this case the pound, is overvalued relative to the dollar. Therefore, the correct statement according to absolute PPP is 'The pound is overvalued relative to the dollar.' The other options presented in the question are incorrect based on the absolute PPP calculation.